Monthly Archives: September 2022

BLS Employment Preview

Heading into today’s BLS employment report, it’s worth summarizing other recent labor market data. Keep in mind, the BLS employment report and the jobs data we review below is of utmost importance to the Fed as they remain hawkish in fear of a price-wage spiral.

ADP shows a marked slow down in job growth. 106k jobs were added in January, down from 253k in December. Leisure and hospitality jobs added 95k jobs accounting for almost 100% of the gain. They do warn some of the weakness is weather related. Per ADP’s Chief Economist- “In January, we saw the impact of weather-related disruptions on employment during our reference week. Hiring was stronger during other weeks of the month, in line with the strength we saw late last year.”

While ADP was weaker, JOLTs data was surprisingly strong. JOLTs is for December, unlike ADP and the BLS employment report, which cover January. The number of job openings rose by 572k to 11 million. Like the ADP report, leisure and hospitality jobs account for a large chunk of the openings. As shown below, the ratio of vacancies to unemployed workers rose to 1.92 from 1.74 in November and 1.81 a year ago. Lastly, the Employment Cost Index (ECI) confirmed a deceleration of wages. The 4% annualized wage growth over the last quarter is still above pre-covid levels, but it’s falling. In summary, there are some signs of weakness, but the data summarized above and recent initial jobless claims data do not lead us to believe the BLS employment report will be troublesome.

labor bls employment

What To Watch Today

Economy

  • 8:30 a.m. ET: Two-Month Payroll Net Revision, January (-28,000 prior)
  • 8:30 a.m. ET: Change in Nonfarm Payrolls, January (190,000 expected, 223,000 prior)
  • 8:30 a.m. ET: Change in Private Payrolls, January (190,000 expected, 220,000 prior)
  • 8:30 a.m. ET: Change in Manufacturing Payrolls, January (6,000 expected, 8,000 prior)
  • 8:30 a.m. ET: Unemployment Rate, January (3.6% expected, 3.5% prior)
  • 8:30 a.m. ET: Average Hourly Earnings, month-over-month, January (0.3% expected, 0.3% prior)
  • 8:30 a.m. ET: Average Hourly Earnings, year-over-year, January (4.3% expected, 4.6% prior)
  • 8:30 a.m. ET: Average Weekly Hours All Employees, January (34.4 expected, 34.3 prior)
  • 8:30 a.m. ET: Labor Force Participation Rate, January (62.3% expected, 62.3% prior)
  • 8:30 a.m. ET: Underemployment Rate, January (6.5% prior)
  • 9:45 a.m. ET: S&P Global U.S. Services PMI, January Final (46.6 prior)
  • 10:00 a.m. ET: S&P Global U.S. Composite PMI, January Final (46.6 prior)
  • 10:00 a.m. ET: ISM Services Index, January (50.5 expected, 49.6 prior, revised to 49.2)

Earnings

Earnings

Market Trading UpdateThe Nasdaq

The Nasdaq has entered the bull market phase as the recent surge has pushed it clear of the 200-DMA and the downtrend from the January highs. While everyone had counted out the FANG stocks, we suggested at the market lows in early November; such was not likely the case. Since then, the Nasdaq has had a spectacular run, with many FANG stocks and beaten-up technology far outpacing the rest of the market.

With the Nasdaq pushing well into 3-standard deviations above the 50-DMA, the MACD “buy signal” at more extreme levels, and the Williams %R Index (%R) near zero, all suggest the market is well due for a pullback. Such a corrective phase should at least see a retest of the downtrend line and the 200-DMA. If the market can work off some overbought conditions but not break technical support levels, such will be a good opportunity to increase technology/growth-related exposures.

The markets are well ahead of fundamentals currently, so be patient chasing markets here.

Market Trading Update

More Warnings about the January Effect

In Thursday’s Commentary, we noted the flaws with the January effect. We also used 2001 as a reason for caution. Per our advice:

In 2001, the Nasdaq started the year with an 8% gain in January. By September, it was down 54% year to date. It rallied to close the year down 35%, resulting in a lot of pain for those following the January effect.

In the table below, Morgan Stanley compares January 2001 to last January. In particular, they show how the 2000 laggards were the top performers in January 2001. Similarly, last years laggards led the way this January. As the title says, Morgan Stanley thinks January’s rally will not end well. Below the table, Morgan Stanley explains that it’s not just the performance of laggards that explains their bearishness. There are other similarities worth noting.

january effect
morgan stanley commentary january effect

Financial Conditions – Another Opinion

Financial conditions, as defined by Powell, are generally easing. His definition of financial conditions heavily emphasizes stock prices, bond yields, and the dollar. As the graph below shows, Vanda Reserach thinks financial conditions are not easing. Their gauge thinks they are tightest since the late 1970s. The factors used for their gauge are things that truly matter to the real economy. If they are correct, the lagged effect of extremely tight financial conditions will result in a recession, and the Fed quickly pivoting to a much more accommodative stance.

tight financial conditions

Small Caps Vs. Large Caps Favor Goldilocks

Jeffrey Marcus from Turning Point Analytics (TPA) thinks the recent outperformance of small cap versus large cap stocks is another indicator that the market is betting on a soft landing, aka the Goldilocks scenario. If Jeff is right, small caps have a lot of ground they can potentially pick up versus large-cap stocks. Per Jeff:

The ratio of Small Caps versus Large Caps broke out of a steep 17-month downtrend in August and appears to have established a series of higher lows. Small Caps are the most vulnerable to an economic downturn and their outperformance is a reason for optimism.

small cap vs large cap stocks

TPA is an add-on service available within SimpleVisor. Click HERE and check out the great research Jeff and TPA provide SimpleVisor subscribers.

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NFIB Survey Suggests A Recession Is Coming

The most recent NFIB (National Federation Of Independent Business) is sending a strong signal of an economic recession. In 2019, the NFIB survey, combined with an inverted yield curve, suggested an impending recession. In 2020, those signals became a reality.

As in 2019, we see many of the same warning signals from the NFIB survey again combined with a high percentage of yield curve inversions. Notably, out of the ten yield spreads we track, which are the most sensitive to economic outcomes, 90% are inverted.

Yield curve inversions vs stocks

A surge of analysis suggests the economy may have a “soft landing,” or rather, avoid a recession, due to the solid monthly employment reports. It is worth noting that while those employment reports remain strong, we should consider the rapid decline in growth. As we have stated previously, the trend of the data is far more important than the monthly number.

employment 3-month average

The rapid decline in the 3-month average of employment growth coincides with a drastic drop in CEO confidence, suggesting that unemployment will continue to rise as the year progresses.

CEO confidence vs employment

These “recession” warning bells get further confirmation from the NFIB survey, which posted a sharp drop in December. Since small businesses employ roughly 50% of the working population, the survey can tell us much about the state of the economy versus the data from Government sources.

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Non-Confidence

In December, the survey declined to 89.8 from 91.9 in November. While that may not sound like much, it is where the deterioration occurred that is most important.

NFIB Confidence survey

It is also important to note that small business confidence is highly correlated to changes in, not surprisingly, small-capitalization stocks. The deviation between small-cap stocks and the NFIB survey will eventually close; the only question is in which direction.

NFIB survey vs small cap stocks

The stock market, and the NFIB report, confirm recession risk is rising. As noted by the NFIB:

“Overall, owners are not optimistic about 2023, sales and business conditions are expected to deteriorate. Owners will focus on their businesses, and do their best to deal with the fallout from all of the uncertainties in a year of slow growth and still-persistent inflation.

Such see this in the average of expected sales over the next quarter and actual sales over the last quarter versus retail sales. We will likely continue to see weakness in the consumer over the coming months. That slowing of demand has consequences.

NFIB sales vs retail sales

The process of “dealing with the fallout” includes actions to mitigate risks imposed on businesses from slower economic demand. Such includes layoffs and terminations, wage cuts, inventory reduction, and reduced capital expenditures. The CEO confidence index highly correlates with earnings, suggesting further defensive corporate actions.

CEO confidence vs employment

Before we dig into the details, let me remind you this is a “sentiment” based survey. Such is a crucial concept to understand.

“Planning” to do something is a far different factor than actually “doing” it.

For example, the survey stated that 17% of business owners are “planning” to increase employment in the next few months. That sounds positive until you look at the trend, which is negative. Furthermore, there is a massive gap between those “plans” and what occurred. Such is one of the many problems with the “job openings” data reported each month. Just because they have a job opening does NOT mean they will fill it.

NFIB survey vs actual employment

Since business owners are sensitive to economic risk, the rise in NON-Confidence in the NFIB survey suggests that more defensive actions are probable in the months ahead. Such is particularly evident when it comes to the overall economic outlook.

NFIB Signals, NFIB Signals A Recession Is Coming…Again

Sentiment Going Negative

Notably, the NFIB is a “sentiment” based survey like many surveys. Such is a crucial concept to understand. As noted, the risk of investing based on improving expectations is problematic as reality can be far different.

Another good example is capital expenditure plans. “Business investment” is a crucial component of the GDP calculation. Small business “plans” to make capital expenditures, which drive economic growth, correlate highly with Real Gross Private Investment. There are two critical points in the chart below.

  1. CapEx plans continue to erode after each recession.
  2. The current decline in CapEx plans is approaching the lows of the economic shutdown and recession.
NFIB Capex plans vs real private investment

As I stated above, “expectations” are very fragile. The “uncertainty” arising from inflation, Russia/Ukraine war, and tighter monetary policy continues to weigh on business owners. As noted in the survey:

“Owners continue to call inflation their top business problem, lamenting the cost increases for their inputs (inventory, supplies, labor, energy, etc.) which compel them to raise their selling prices to cover the costs.

The negative impact of the dramatic increase in interest rates has not been fully felt, and more rate hikes are almost certain early in the year.”

Despite the rash of analysis suggesting a soft landing scenario for the economy this year, the NFIB survey does not share that sentiment. As noted, the linkage between the economic outlook and CapEx plans confirms that business owners are concerned about committing capital in an uncertain environment. While the most recent survey showed hope about the “economy,” they remain unwilling to “bet” their capital on it.

Capex vs Economic growth

Not surprisingly, there is a high correlation between capital expenditure plans and economic outlooks. Since business owners are the “boots on the ground” for the economy, their perspective tends to be a very accurate leading indicator. Notably, their current outlook does not support the idea of avoiding a recession in 2023.

NFIB Signals, NFIB Signals A Recession Is Coming…Again

Don’t Ignore The Data

We again see many of the early warning signs of an economic downturn. While such doesn’t guarantee a recession, it does suggest the risks of an economic downturn are markedly higher.

As noted above, in 2007, the market warned of a recession 14 months before the recognition. 

In 2019, it was just 5-months.

No one knows the timing of the recognition of the next recession. However, with economic growth slowing, the Fed still hiking rates, and inflation weighing on consumers, a “soft landing” seems overly optimistic.

The last time the NFIB Signals were this weak, the Government started sending checks to households, and the Fed introduced $120 billion in monthly “QE.” Furthermore, Treasury bond rates fell to 0.5% as the Fed scrambled to buy junk bond ETFs.

No two recessions are ever the same. However, if the economy does falter, and companies continue to take more defensive actions to offset the risk of the decline, it is difficult to fathom how stock market prices avoid repricing lower to accommodate for falling earnings.

The Fed Funds Rate Inches Higher

As expected, the FOMC increased the Fed Funds rate by 25bps to 4.50%. They also anticipate that “ongoing increases in the target range will be appropriate.” Doing so would likely leave the Fed Funds rate at 5.00% or higher when they stop hiking rates. If all goes according to the Fed’s plan, markets could get interesting in May. The Fed is transparent that it is willing to stall hiking the Fed Funds rate, but they show no interest in reducing rates. Conversely, the markets imply 50bps in cuts in the second half of 2023. Such a divergence of views often leads to market volatility as either the Fed shifts toward market views or vice versa. As Bloomberg depicts on their current magazine cover, the bulls and Powell are going head to head.

Also of note, the Fed is not making any changes to QT. QT drives liquidity for financial markets in conjunction with its reverse repurchase (RRP) repo program. In the last quarter, the Fed’s RRP program offset a significant amount of the decline in liquidity due to QT. Will the Fed continue to use RRP to manage financial system liquidity? If so, the Fed may be able to manage stock prices to meet their goals.

powell fed funds rate bull market

What To Watch Today

Economy

  • 7:30 a.m. ET: Challenger Job Cuts, year-over-year, January (129.1% prior)
  • 8:30 a.m. ET: Unit Labor Costs, Q4 Preliminary (1.5% expected, 2.4% prior)
  • 8:30 a.m. ET: Nonfarm Productivity, Q4 Preliminary (2.4% expected, 0.8% prior)
  • 8:30 a.m. ET: Initial Jobless Claims, week ended Jan. 28 (195,000 expected, 186,000 prior)
  • 8:30 a.m. ET: Continuing Claims, week ended Jan. 21 (1.684 expected, 1.675 million prior)
  • 10:00 a.m. ET: Factory Orders, December (2.3% expected, -1.8% prior)
  • 10:00 a.m. ET: Factory Orders Excluding Transportation, December (0.2% prior)
  • 10:00 a.m. ET: Durable Goods Orders, December Final (5.6% prior)
  • 10:00 a.m. ET: Durables Excluding Transportation, December Final (-0.1% expected, -0.1% prior)
  • 10:00 a.m. ET: Non-defense Capital Goods Orders Excl. Aircraft, December Final (-0.2% prior)
  • 10:00 a.m. ET: Non-defense Capital Goods Shipments Excl. Aircraft, December Final (-0.4% prior)

Earnings

Earnings

The Bull Market Is Back!

Despite what you may have heard, the bull market is back. Good news is good news, bad news is good news, and the Fed no longer matters. As such, it is just time to pony up and buy the dips and, more importantly, buy the stuff with the worst possible fundamentals because that is where the money is to be made.

While you may detect sarcasm, the message isn’t wrong. The breakout above the downtrend line, the confirmed inverse head-and-shoulders bottom, and the approaching “golden cross” all suggest that the bulls are in charge for now. Yesterday’s move confirmed the recent breakout by taking out the November highs. Such now puts the 4200-4350 as the next logical target for the market.

Market Trading Update

The market is getting decently overbought now, with many companies driving the market now trading well into 3-standard deviation territory. While earnings are getting downgraded, companies are beating lowered estimates which are good enough for the bulls. It is important not to fight the market but let the market tell you what it wants to do. For now, we are back to buying the dips until that changes.

What’s Powell Thinking?

The following quotes from yesterday’s press conference help better appreciate Jerome Powell’s views on the economy, inflation, and monetary policy.

  • Despite the slowdown in growth, the labor market remains extremely tight.”
  • Labor demand far outweighs supply.”
  • The employment cost index (ECI) is a crucial report the Fed follows to understand how high wages pressure inflation. Tuesday’s ECI report was encouraging, but it is still too high.
  • They can’t allow a price-wage spiral to form.
  • “Inflation remains well above goal.”
  • “Restoring price stability will require maintaining a restrictive stance for some time”
  • “Shifting to a slower pace (rate hikes) allows the FOMC time to assess progress.”
  • “It is important that financial conditions (stock prices, yields, and the dollar) continue to reflect the policy restraints we have imposed.”
  • Core services, representing 56% of inflation, are not yet showing signs that prices are coming down. They “have a lot of work left to do” until core service prices slow. Until core service prices decrease, they will remain vigilant to ensure they “complete the job.
  • This disinflation process has started.” – “Primarily in goods, but that’s only about a quarter of the PCE index.”
  • The Fed sees disinflation in the pipeline for rent and the housing market.
  • The committee spent “ample time” debating when they might pause rate hikes.
  • Three month measures of inflation are low, but it’s primarily due to unsustainable “transitory” declines in good prices.
  • “We are in the early stages of disinflation.”
  • “Covid is no longer playing an important role in our economy.”

Our Takeaway

Powell really didn’t break new ground, but he did appear more flexible about the possibility the Fed eases once they are comfortable inflation is slayed. He remains vigilant that the tight labor market keeps upward pressure on inflation. The Fed is very concerned with core service prices. Likely when non-housing services show disinflation, the Fed will get more comfortable. He stressed on numerous occasions that this is a unique environment to forecast inflation and growth. Thus, a highly restrictive policy is warranted to ensure inflation gets to 2%. “This is not a standard business cycle.”Certaninty is not appropriate.

Is the January Effect Real?

The S&P 500 was up 7% in January, prompting some investors to assume 2023 will be a good year. The January effect, a Wall Street myth, assumes that as goes January as goes the year. While the January effect may sound good in theory, the same theory works for every month. The fact is that stock prices most often trend higher. As such, the momentum in January is also part of the same momentum that fueled stocks in the prior months and the coming months. As the table shows, the January effect is, on average, bested by the April and November effect. Even in the worst month historically, October, a gain for the month results in a gain for the next 12 months three-quarters of the time.

stocks january effect

The second graph provides a little food for thought for those looking at January 2023 returns and getting bullish. In 2001, the Nasdaq started the year with an 8% gain in January. By September, it was down 54% year to date. It rallied to close the year down 35%, resulting in a lot of pain for those following the January effect.

nasdaq january effect

ChatGPT is Off to a Great Start

In our Commnetary from January 27, we discussed how Microsoft’s recent purchase of part of ChatGPT would benefit the company. The graph below shows that the uptake of ChatGPT AI technology is off to an amazing start. Facebook took ten months to reach one million users, and Twitter took two years. ChatGPT reached one million users in less than a week! As we wrote a week ago:

The potential Chat GPT applications are immense, and the benefits will likely flow to Microsoft shareholders.

chatgpt million users

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S&P 500 Monthly Valuation & Analysis Review – 01-31-23

S&P 500 Monthly Valuation & Analysis Review: 01-31-23

Also, read our commentary on why low rates don’t justify high valuations.


J. Brett Freeze, CFA, founder of Global Technical Analysis. Each month Brett will provide you with their valuable S&P 500 Valuation Chart Book. This unique analysis provides an invaluable long-term perspective of equity valuations. If you are interested in learning more about their services, please connect with them.

FOMC Cheat Sheet

At 2 pm ET, the FOMC releases its Fed Funds rate decision, and Powell will hold a press conference afterward. To help guide you through what might be a volatile afternoon trading session, we present ING’s FOMC cheat sheet, followed by our thoughts. ING presents four scenarios for how the Fed characterizes inflation, growth, interest rates, and QT. As shown to the right of the scenarios, the FOMC cheat sheet also includes expectations for how the various scenarios could play out in the bond and currency markets.

We think the Fed will land somewhere between the base case and hawkish. Here are our expectations on the policy factors:

  • Inflation- The Fed will claim it remains too high but show some optimism it has peaked. However, they may offer caution due to concern for a rebound in inflation.
  • Growth- ING’s base forecast aligns with our expectations. There are very few indicators the jobs market is weakening.
  • Interest rates- A 25bps hike is very likely, and discussion of one or two more at the next two meetings. More importantly, they will stick with their call that Fed Funds stay at their terminal rate for the remainder of 2023.
  • Balance Sheet- Like ING, we highly doubt they make any changes.
ing fomc cheat sheet

What To Watch Today

Economy

  • 7:00 a.m. ET: MBA Mortgage Applications, week ended Jan. 27 (7.0% prior)
  • 8:15 a.m. ET: ADP Employment Change, January (170,000 expected, 235,000 prior)
  • 9:45 a.m. ET: S&P Global U.S. Manufacturing PMI, January Final (46.8 prior)
  • 10:00 a.m. ET: Construction Spending, month-over-month, December (0.0% expected, 0.2% prior)
  • 10:00 a.m. ET: ISM Manufacturing, January (48.0 expected, 58.4 prior)
  • 10:00 a.m. ET: JOLTS Job Openings, December (10.300 million expected, 10.458 million prior)
  • 2:00 a.m. ET: FOMC Rate Decision (Lower Bound), Feb. 1 (4.50% expected, 4.25% prior)
  • 2:00 a.m. ET: FOMC Rate Decision (Upper Bound), Feb. 1 (4.75% expected, 4.50% prior)
  • 2:00 a.m. ET: Interest on Reserve Balances Rate, Feb. 2 (4.68% expected, 4.40% prior)
  • WARDS Total Vehicle Sales, November (15.50 million expected, 13.31 prior)

Earnings

Earnings

Market Trading Update

Time for a dollar reversal? Since the beginning of the year, commodities like gold and emerging markets have been strongly outperforming due to the drop in the U.S. dollar. However, now that the dollar decline has gotten very extended, it is due for a fairly strong reversal arguing for profit-taking in the winning trades of January.

Dollar Chart

Two more key points that argue for a near-term reversal in the dollar. First, the 12-week rate of change is extreme, and history suggests a rebound will follow.

US Dollar chart

Furthermore, just as with the stock market, when everyone is on the same side of the trade, such provides the fuel for a significant reversal. Currently, there is a decent short position against the dollar.

Dollar net speculative holdings

Why is this important? Because the dollar decline has fueled the asset chase since December from gold to commodities, to emerging markets, and risk assets in general. As shown, the Morgan Stanley “Global Risk Demand Index” (STGRDI) has risen sharply and is nearing +3 standard deviation and is significantly higher than the reading on the 12th of August (4 days before the markets peaked).

Morgan Stanley Risk Gauge

If the dollar does reverse, we would also expect to see dollar-denominated trades reverse.

Don’t forget to take profits.’

UPS Struggles While Exxon Prints Money

UPS and Exxon are both solid barometers of the economy. When the economy runs strong, commerce and traffic are on the rise, often boosting profits for companies like UPS and Exxon.

Yesterday, Q4 revenues at UPS came up short of expectations, although its EPS beat slightly on better margins. The company guided 2023 revenue guidance lower as well. Despite the weak revenue and poor outlook, the stock rose. Fueling the gain, the company authorized up to $5 billion in stock buybacks and raised its dividend.

Exxon, on the other hand, bolstered by high oil prices and strong demand, posted a record annual profit of $59 billion. The profit far exceeded the prior high from 2008 ($45.2 billion). Revenues fell short of estimates, but EPS was better than expected. Unlike UPS, XOM did not accelerate share buybacks.

The companies’ earnings reports point to the economy’s confusing state. While Exxon is recording record profits, revenues are declining at UPS, despite increasing the prices they charge their customers. Some sectors and bits of economic data point to a recession, while others point to robust growth. The graph below shows the stunning divergence between the performance of the companies stock prices.

exxon and ups

Treasury Sales are Red Hot

Bespoke Investmentment Group put out a great piece showing that the U.S. Treasury auctions in January were well-demanded by investors. Per Bespoke, January was a record month for Treasury sales. Every auction and bond reopening occurred at a lower yield than where the bond was trading before the respective auctions. The second graph below shows that the auctions occurred 2.3bps below the then-market yield. Such is much better than any month in at least ten years. Indirect bidders, often foreign investors, bought approximately 75% of January’s issuance. The graphs and commentary below are all courtesy of Bespoke.

bespoke treasury stats
bespoke treasury auctions

Foreigners are Buying Gold

The FT notes that the central bank purchases of gold in 2022 rose to a level last seen in 1967. Why? The FT quotes an analyst that claims that a “lack of counterparty risk” as compared to currencies “under the control of foreign governments” was a key reason. In other words, after the U.S. froze Russia’s dollar reserves, other central banks wanted to move some of their assets somewhere they would be out of reach from other governments.

central bank gold purchases

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Turmoil Lurks Around The Corner

On October 12, 1987, a week before Black Monday, the Wall Street Journal warned of the potential for significant market turmoil. Per the article: The use of portfolio insurance “could snowball into a stunning rout for stocks.” Today, we are increasingly alarmed that another trading tool similar to portfolio insurance could set markets up for a bout of turmoil. 

The quote above and a detailed analysis of Black Monday can be found in a Federal Reserve white paper entitled A Brief history of the 1987 Stock Market Crash.

Despite the growing risk to foster market turmoil, 0DTE is a term few investors have heard of.

0DTE stands for zero days to options expiration. These are put-and-call options on individual stocks and indexes that expire within 24 hours. 0DTE options may seem like speculative YOLO (you only live once) bets at first glance. However, when one appreciates how brokers hedge options, they then grasp the potential for these options to generate significant volatility in individual stocks and the market. 

Before exploring 0DTE options, it’s worth briefly discussing portfolio insurance’s role in Black Monday 1987.

1987 Portfolio Insurance

One of our first reactions to hearing of the recent popularity of 0DTE trades was to recall Black Monday and the 22.6% crash of the Dow Jones Industrial Average on October 19, 1987. There are several causes for the turmoil, but the factor that significantly amplified the decline was portfolio insurance.

At the time, institutional investors were buying portfolio insurance from Wall Street brokers to help protect against losses. During market declines, the brokers’ computer algorithms would automatically sell S&P 500 futures contracts short. As the market sold off further, the algorithms would sell more contracts.

As the programs sold, they pushed markets lower, necessitating more portfolio insurance-related selling. Selling begat selling, and a correction turned into an avalanche of panic.

The following quote is from a Wall Street Journal article rehashing the turmoil:

The strategy backfired, probably because too many institutions were doing the same thing at more or less the same time. They pushed stock prices into free fall and individual investors under the bus.

1987 wsj market crash
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0DTE Options

The popularity of 0DTE options is rising precipitously. As the graph below shows, half of the volume of options on S&P 500 futures are 0DTE. That dwarfs the 5-10% share existing before the pandemic.

0dte options

Individual and institutional investors are using options that have a very short time until expiry for speculative and hedging purposes. It is also likely investors may be using 0DTE options to manipulate markets. Regardless of the objectives, 0DTE options have a similar feature as portfolio insurance; they can significantly intensify market moves.

To reiterate the WSJ quote:The strategy backfired, probably because too many institutions were doing the same thing at more or less the same time.” Sound familiar?

How Manipulation Creates Signifcant Instability

To help better appreciate the risk of 0DTE options, we walk through a hypothetical example using Tesla stock. This case uses data from the early afternoon on January 25, 2023. After the close that day, Tesla reported its quarterly earnings.

Hypothetical hedge Fund ABC owns 100,000 shares of Tesla stock (TSLA). TSLA was trading for $144, which meant ABC had a $14,400,000 investment in TSLA. With earnings due shortly, ABC wanted a low-cost trade to juice their returns if earnings were better than expected.

One such way is 0DTE options. To do so, they could buy calls with a $160 strike that expired in a day. At the time, the price per 0DTE call was $1.36. Each call option controls 100 shares. If they chose, buying 1,000 calls would give them the right to purchase 100,000 shares at $160. The options cost was $136,000 or about 1% of their total Tesla investment. If TSLA shares flopped on earnings, they would lose 1% on the options. If the stock rose, they would likely sell the options and could easily double or triple their return. More importantly, their calls could force significantly more buying if the stock rose.

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Delta Hedging Begets Delta Hedging

As frequently occurs, ABC indirectly buys calls from a Wall Street dealer. Most dealers run managed books meaning they have limited risk-taking tolerance. Accordingly, they often hedge their risks. In this case, the dealer’s risk is an increase in the price of Tesla.

Dealers use a hedging method called delta hedging. An option’s delta estimates how much an option’s value may change for a $1 move up or down in the underlying security. The delta at the time of the trade was .15. For each $1 that TSLA shares rose, the options would increase by 15 cents. The delta increases toward 1.0 as the price approaches the strike price and falls toward zero as the price declines.

The dealer might initially delta-hedge the calls in our scenario by buying 15,000 shares (.15*100,000). As the price rises or falls, the number of shares they own will change according to the delta. The table below approximates the delta for Tesla shares on that day for a range of prices.

delta hedging example tsla

If the hedge fund is right and Tesla has excellent earnings, the stock will jump and force the dealer to buy more Tesla. The further it rises, the more shares they must buy. As the dealer and other dealers increase their hedges, the buying pressure on Tesla shares increases and pushes the delta higher. Buying begets buying.

Options on The Market

The Tesla 0DTE example pertains to the movement of one stock. While Tesla’s price may be more volatile than it would have been without 0DTE options, its effect on the broad market is limited.

More concerning, investors are buying 0DTE calls and puts on the S&P 500 and other indexes. Often such options are purchased in advance of potentially market-moving events. Recently, CPI, Fed meetings, and employment reports have drawn sizeable interest from 0DTE traders.

Suppose 0DTE volume is large enough, and options buyers are betting on the same directional market move. In that case, the environment becomes ripe for significant market instability if dealers are forced to aggressively delta hedge. Adding strength to such an event, investors become irrational when markets fall precipitously. A considerable downward move could trigger other investors to panic sell. Selling could beget selling, and a few percent loss could quickly turn into a severe decline.

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Summary

If you take one thing away from this article, it is that for every option, there is likely a bank/dealer on the other side of the trade. Risk management protocols force dealers to buy or sell up to 100 shares of the stock or index for each option. It takes little money for a hedge fund to manipulate stock or index prices and, therefore, little money to create market turmoil.

Unlike portfolio insurance, delta hedging is limited as the delta can only go to one or zero. However, a heavy dose of delta hedging could cause panic selling among other market players. Fear can beget fear!  

Closing Note

When we calculated the TSLA 0DTE example, Tesla closed the day at 144.43 minutes before the company reported its Q4 earnings. Its shares shot 10% higher the next day on the most volume in six months. 0DTE certainly helped TSLA shareholders!

tesla delta hedging 0dte

Sector Rotation- 2022 vs 2023

While only a month into the new year, 2023 has been marked by a sector rotation that has mainly been opposite of last year’s rotation trends. Thus far, consumer staples, utilities, and healthcare stocks are underperforming the S&P 500 by about 8%. In 2022, those three sectors outperformed as investor rotations focused on conservative, dividend, and value traits. This year, communications, last year’s worst-performing sector, is beating the S&P 500 by approximately 10%. Following closely behind is 2022’s second-worst performer, consumer discretionary. The graph below shows what worked last year is not working this year and vice versa.

The big question in 2023 is whether or not last year’s sector rotation trends will hold again in 2023. If a durable bottom has formed, the economy has a soft landing, and the Fed gently lowers rates, we should expect high growth and beaten-down sectors to follow their January performance. However, a deeper recession bodes well for 2022’s conservatism.

sector rotation

What To Watch Today

Economy

  • 8:30 a.m. ET: Employment Cost Index, Q4 (1.1% expected, 1.2% prior)
  • 9:00 a.m. ET: FHFA Housing Pricing Index, November (-0.5% expected, 0.0% prior)
  • 9:00 a.m. ET: S&P CoreLogic Case-Shiller 20-City Composite, MoM, November (-0.65% expected, -0.52% prior)
  • 9:00 a.m. ET: S&P CoreLogic Case-Shiller 20-City Composite, YoYr, November (6.70% expected, 8.64% prior)
  • 9:00 a.m. ET: S&P CoreLogic Case-Shiller U.S. National Home Price Index, November (9.24% prior)
  • 9:45 a.m. ET: MNI Chicago PMI, January (45.1 expected, 44.9 prior)
  • 10:00 a.m. ET: Conference Board Consumer Confidence, January (109.0 expected, 108.3 prior)
  • 10:00 a.m. ET: Conference Board Present Situation, January (147.2 prior)
  • 10:00 a.m. ET: Conference Board Expectations, January (82.4 prior)

Earnings

Earninigs

Market Trading Update

Yesterday morning, we took some exposure off the table early ahead of the Fed announcement on Wednesday. As stated previously, we expect a fairly hawkish statement from Jerome Powell, which could lower stock prices soon. However, a pullback would not be bad if the breakout levels that previously provided resistance are turned into support. Those levels are, as shown, the downtrend line from the January 2022 peak, the 200-DMA, and the 50- and 20-DMA convergence. That cluster of support is critical for the bullish rally to continue. A failure at these levels will lead to a retest of the December lows.

There is a lot of potential support in the 3975 area, but for the breakout to be confirmed, the market will need to break above the recent highs at 4071. If such occurs, technically, a new bull market will be in process. However, there is a lot of risk in the market currently, so we reduced our exposure for now.

Market Trading Update

EV Challenges

EV market share for new vehicles is likely to reach 40% by 2030, per S&P Global. If such inroads into the auto market are made, the United States may have to rethink its relations with China and other countries. Almost all of the metals used in EV production are not from the U.S. More concerning, China is the leading processor of EV metals. The more we isolate ourselves from China, the more we must process or find another friendly nation to process for us. Such will be a big political challenge if U.S. automakers are to lead the world in EV production.

ev metal production processing

Managing QT

Over the last four months, the Fed has reduced its balance sheet by $350 billion. Typically such a change would weigh on the financial markets. This time, it appears the Fed is trying to blunt the effect of QT. In our article, S&P 3500, we share a model that tracks the three sources of financial market liquidity the Fed controls. Per the article:

With an understanding of the three key factors driving banking system liquidity, we can create a Fed liquidity model. The size of the Fed’s assets less the sum of the TGA and RRP equals the amount of Fed-generated liquidity in the system. Recent changes in net liquidity shed light on how the S&P 500 trends.

The Fed controls its balance sheet and the reverse repurchase program (RRP). As the usage of the RRP program declines, liquidity re-enters the system. Conversely, liquidity is taken from the system as the Fed reduces its balance sheet. Therefore the Fed can better manage liquidity with RRP despite doing QT. The graph below shows that since the end of the third quarter of 2022, net liquidity has only fallen by $74 billion, despite $350 billion of QT. RRP may allow the Fed to reduce its balance sheet with less financial market harm than in the past.

qt rrp fed liquidity

Hedge Funds are Bearish on Bonds

Per the latest round of CFTC data, hedge funds and other institutional speculators are holding a net record number of short positions on U.S. Treasury bonds. By default, banks on the other side of the trade currently hold a record number of long bond futures positions. The prior record was set in mid to late 2018. TLT bottomed on October 3, 2018, at 103.16. By the end of 2019, before the pandemic struck, it was trading at 135.90. Weaker economic activity, accompanied by the Fed cutting rates by .75% in 2019 and short covering by speculative traders, fueled the rally.

Further supporting a bullish outlook is the following interview with Stephen Roach from Bloomberg:

“Historical data for US bond market returns tells us that the best time to buy bonds is on the penultimate hike:” HSBC’s Steven Major. Recent bond moves suggest the penultimate Fed rate hike is close. “History suggests this is an important moment.”

bonds bearish tlt

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Recession Forecasts At Odds With Bullish Formations

Despite mounting evidence supporting recession forecasts, the stock market remains at odds with that outlook. Such leaves investors in a predicament of avoiding a further drawdown in the equity markets but not wanting to miss out on a potential recovery.

It is hard to argue with the recession forecasts that currently proliferate the headlines. For example, this excellent piece from Simon White from Bloomberg makes an important observation.

Stocks will be unable to post a durable rally and exit their bear market until the cycle turns. As the chart below shows, it’s not until leading data start to outperform coincident data once more that stocks turn up.

Unfortunately, when leading data are as depressed as they are today relative to coincident data, the cycle does not turn without there being a recession. Based on the historical data, stocks have another 15% or so downside if the US has a recession.”

LEI index versus stock market prices.

The Leading Economic Index is a significant indicator. In particular, we monitor the 6-month ROC in the Index as it highly correlates to corporate earnings and has a perfect track record in forecasting recessions. Both the 6-month ROC in the LEI and our broad Economic Composite Index (more than 100 individual data points) suggest a recession is imminent.

Economic output composite index versus LEI

In the most recent report, the Conference Board issued its recession forecast regarding the sharp drop in the Leading Index.

“There was widespread weakness among leading indicators in December, indicating deteriorating conditions for labor markets, manufacturing, housing construction, and financial markets in the months ahead. Meanwhile, the coincident economic index (CEI) has not weakened in the same fashion as the LEI because labor market-related indicators (employment and personal income) remain robust. Nonetheless, industrial production— also a component of the CEI—fell for the third straight month. Overall economic activity will likely turn negative in the coming quarters before picking up again in the final quarter of 2023.”

Yet, despite the data supporting the recession forecasts, the market continues to disregard those warnings.

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Bullish Formations

Over the last few weeks, we repeatedly discussed the consolidation occurring in the market. The market has continued to trade higher despite falling earnings and weaker outlooks. Notably, several bullish formations are occurring that historically denote higher prices over the short- to intermediate-term. For example, the compression of prices between the downtrend line from the January 2022 peak and the rising lows since October was an important focal point for investors. Such is shown in the chart below. That compression acts as a “spring,” and when prices break out, the subsequent move tends to be pretty powerful.

Market Downtrend Breakout

As you will note, since January’s market peak, each attempt to break above the falling downtrend line was a “head fake,” leading to lower prices. The break above that downtrend line suggests that a pathway higher for prices is now occurring. While we do NOT have evidence of a clear sustained break above that downtrend, the risk of a “head fake” remains elevated.

But, as shown below, several other technical improvements to the broad market are worth watching, which also defy the recession forecasts.

Since the October lows, the market has been building a rather substantial price base. As discussed in the “Bull Bear Weekly Report,” the inverse “head-and-shoulder” pattern already suggests a market bottom has formed. A solid break above the downtrend line (with a successful retest) would confirm the completion of that pattern.

Furthermore, the 50-DMA is rapidly closing in on a cross above the declining 200-DMA. Such is known as the “golden cross” and historically signifies a more bullish setup for markets moving forward.

The golden cross of market moving averages.

Lastly, overall “bullish sentiment” is also improving markedly, with the number of stocks on bullish “buy” signals rising to the highest since March 2022.

Bullish percent index

Should we ignore the recession forecasts?

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History Still Suggests Caution

While it is possible that some bad news, or an overly aggressive Fed, could cause a reversal to these bullish formations, for now, they continue to support higher prices. Such seems odd given the negative flow of recession forecasts and deteriorating earnings data. However, historically, market prices tend to trough 6-9 months before earnings bottom. Such is because the market anticipates outcomes and was the subject of this week’s post on “Contrarianism.”

As a contrarian investor, excesses get built when everyone is on the same side of the trade. Everyone is so bearish the markets could respond in a manner no one expects. This is why equities have historically bottomed between 6-to-9 months before the earnings trough.”

Equities trough vs earnings trough

There are plenty of reasons to be very concerned about the market over the next few months. Given the market leads the economy, we must respect the market’s action today for potentially what it is telling us about tomorrow. 

However, while we should not discount the improving technicals, we can not entirely dismiss the recession forecasts either.

History is exceptionally clear about the impact of higher interest rates on economic growth, employment, and personal incomes. As we discussed in the “Fed Myth,” there has never been such a thing as a “soft landing.”

“There were three periods where the Federal Reserve hiked rates and achieved a ‘soft landing,’ economically speaking. However, the reality was that those periods were not ‘pain-free’ events for the financial markets. The chart below adds the ‘crisis events’ that occurred as the Fed hiked rates.”

Fed funds vs the market and crisis events

Crucially, a recession, or “hard landing,” followed the last five instances when inflation peaked above 5%. Those periods were 1948, 1951, 1970, 1974, 1980, 1990, and 2008. Currently, inflation is well above 5% throughout 2022.

CPI annual inflation rate

Could this time be different? Absolutely,

The bullish formations in the market indeed show investors are hopeful of such an outcome.

Unfortunately, there is a lot of history that suggests otherwise.

Fed Funds Forecasts- Mind The Gap

As we consider how the Fed might adjust the Fed Funds rate on Wednesday, it’s also worth contemplating various Fed Funds forecasts for this year and next. The graph below shows there is a decent gap in Fed Fund Forecasts between what the Fed projects (green), what the market implies (black), and historical observations of rate cuts (black). As time marches on, the Fed Funds forecasts will converge. Depending on which of the three forecasts, or any other paths, the markets may offer significant volatility as the Fed’s or investors’ outlooks adopt a new outlook.

The three Fed Funds forecasts shown below are based on the following:

  • FOMC- The Fed’s 12/15/2022 median year-end Fed Fund forecasts
  • FF Futures- Market implied rates based on Fed Funds futures
  • FF Historical- Based on the last four recessions. On average, Fed Funds fell by 4.76% over 1.5 years, or 0.29% monthly.
fed funds forecasts

What To Watch Today

Economy

  • 10:30 a.m. ET: Dallas Fed Manufacturing Activity, January (-15.0 expected, -18.8 during prior month)

Earnings

Earings

Market Trading Update

Over the last few weeks, we repeatedly discussed the consolidation occurring in the market. The compression of prices between the downtrend line from the January 2022 peak and the rising lows since October was an important focal point for investors. Such is shown in the chart below.

Market Downtrend Breakout

As you will note, since January’s market peak, each attempt to break above the falling downtrend line was a “head fake,” leading to lower prices. The good news is that, eventually, this cycle will end. At some point, the market will effectively “price in” the worst outcomes, and a break above the downtrend line will become sustainable. Such will confirm the beginning of a new bullish cycle for prices.

The evidence of a clear sustained break above the downtrend is not evident. That keeps the risk of a “head fake” high for now. But, as shown below, several technical improvements to the broad market are worth watching.

While the flow of economic news and media headlines are filled with stories of an impending recession, the market has been firming since October, suggesting a potentially different outcome. As we noted, the inverse “head-and-shoulder” pattern already suggests a market bottom has formed. A solid break above the downtrend line would confirm the completion of that pattern.

Furthermore, the market is not extremely overbought, and shorter-term moving averages are slopping positively. Notably, the 50-DMA is rapidly closing in on a cross above the declining 200-DMA. Such is known as the “golden cross” and historically signifies a more bullish setup for markets moving forward.

Market Trading Update 2

While it is possible that some bad news or an overly aggressive Fed could cause a “head fake” in the market short-term. Many of these bullish signals will complete in the months ahead. While that seems odd given the negative flow of economic and earnings data near term, historically, market prices tend to trough 6-9 months before earnings bottom. Such is because the market anticipates outcomes and was the subject of this week’s post on “Contrarianism.”

As a contrarian investor, excesses get built when everyone is on the same side of the trade. Everyone is so bearish the markets could respond in a manner no one expects. This is why equities have historically bottomed between 6-to-9 months before the earnings trough.”

Equities trough before earnings

There are plenty of reasons to be very concerned about the market over the next few months. Given the market leads the economy, we must respect the market’s action today for potentially what it is telling us about tomorrow. 

While this may be a “head fake” currently, I wouldn’t entirely dismiss the message of improving technicals either.

The Week Ahead

Between the Fed meeting on Wednesday, Unemployment on Friday, and a slew of earnings reports from many large companies, this will be a significant and possibly volatile week ahead for the markets.

At 2 pm ET on Wednesday, the Fed will likely increase the Fed Funds rate by 25bps. Following, at 2:30, Jerome Powell will answer questions from the press. The Fed will maintain its hawkish stance and remain vigilant against inflation. The bigger question is how the markets will interpret it. If the Fed lets on that they are more comfortable that inflation is peaking and falling, the markets may continue higher. However, if the Fed offers concern that tight labor markets, wage pressures, and financial conditions might keep inflation higher for longer, the bears may win the day.

JOLTS and ADP on Wednesday, along with the BLS employment report on Friday, will update the status of the labor markets. Based on recent initial jobless claims and continuing claims, it’s likely the data will continue to show a robust labor market. ISM manufacturing on Wednesday and services on Friday will provide a real-time look at sentiment among business leaders. ISM has proven to be a great leading economic indicator. Assuming it stays below 50, it will continue to signal a recession later this year.

Apple, Google, Amazon, Meta, Eli Lilly, McDonald’s, Shell, and a host of other large companies report earnings this week.

NBER Recession Factors

The NBER, not GDP, is the official determinant of recessions. Accordingly, we thought it might be insightful to understand which factors they prefer to use to help guide their decisions. In the NBER’s Business Cycle Dating guide, we found the following:

In recent decades, the two measures we have put the most weight on are real personal income less transfers and nonfarm payroll employment.

Of the data the NBER tracks, real personal Income (excluding government subsidies and inflation) and employment are significant. The employment market is still red hot and shows few signs of slowing down. However, as the EPB Research graph shows below, real personal income is well below the last decade’s trend and below levels of over a year ago. While far from enough evidence to call a recession, if employment and general economic activity decline, the threshold for an official recession designation may be closer than many think.

real personal income recession fed funds

Enhanced Fundamentals

SimpleVisor has made a substantial enhancement allowing investors to chart fundamental data and their growth trends. The screenshot below shows users can chart various data from the income statement, balance sheet, and cash flow statement. The graph shows revenues for DUK for the last 20 years on an annual basis. Absolute and percentage growth trends can be applied to the graph. We will be adding valuations and financial ratios shortly.

simplevisor fundamental data graphing stocks

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Is Chat GPT Good For Microsoft’s Earnings?

We asked Chat GPT, the new artificial intelligence (AI) engine, that exact question. The answer follows below:

Chat GPT is a good way to improve Microsoft’s earnings because it allows users to communicate with each other directly, which can help improve customer service and product quality. Additionally, it can help Microsoft attract new customers and retain existing ones.

Chat GPT is a fantastic advance in AI that can be used for many businesses and individual applications. Don’t believe us? Click HERE and let Chat GPT write an essay, song lyrics, a Valentine’s Day poem, or even computer code. Earlier this month, Microsoft bought approximately a third of Chat GPT for $10 billion. Microsoft’s Bing web browser plans on introducing Chat GPT technology to the public in late March. Instead of providing links to keywords you search for, Bing may provide you directly with the information. Further, the Microsoft suite of Office products can easily become a platform for users to take advantage of Chat GPT functionality. The potential Chat GPT applications are immense, and the benefits will likely flow to Microsoft shareholders. As the graph shows, Bing has a lot of market share it can steal from Google.

google bing web search engine market share

What To Watch Today

Economy

  • 8:30 a.m. ET: Personal Income, month-over-month, December (0.2% expected, 0.4% prior)
  • 8:30 a.m. ET: Personal Spending, month-over-month, December (-0.1% expected, 0.1% prior)
  • 8:30 a.m. ET: Real Personal Spending, month-over-month, December (-0.1% expected, 0.0% prior)
  • 8:30 a.m. ET: PCE Deflator, month-over-month, December (0.0% expected, 0.1% prior)
  • 8:30 a.m. ET: PCE Deflator, year-over-year, December (5.0% expected, 5.5% prior)
  • 8:30 a.m. ET: PCE Core Deflator, month-over-month, December (0.3% expected, 0.2% prior)
  • 8:30 a.m. ET: PCE Core Deflator, year-over-year, December (4.4% expected, 4.7% prior)
  • 10:00 a.m. ET: Pending Home Sales, month-over-month, December (-1.0% expected, -4.0% prior)
  • 10:00 a.m. ET: University of Michigan Consumer Sentiment, January Final (64.6 expected, 64.6 prior)
  • 11:00 a.m. ET: Kansas City Fed Services Activity, January (-5 prior)

Earnings

Earnings Calendar

Market Trading Update

FINALLY! A market breakout worth having. After a successful retest of the downtrend from the January peak, the breakout yesterday took the market above the neckline of the inverse head-and-shoulders pattern. With this breakout, the market is sending a pretty strong message ahead of the Fed that the bulls are in charge. However, don’t discount the Fed entirely. Jerome Powell still carries a big hammer when it comes to market sentiment.

Market Trading Update 1

The breakout of the downtrend also pulls the 50-DMA ever closer to a “golden cross” (when the 50-DMA crosses above the 200-DMA) which historically suggests higher prices over the intermediate term. The MACD buy signal is not extended, and the markets are not extremely overbought. We have recently added exposure to this rally, but we remain cautious ahead of the Fed meeting next week. Once that meeting is behind us, we will have much better visibility on further increasing equity exposure.

Market Trading Update 2

While the market is certainly pricing in a “soft landing” scenario currently, a more difficult outcome is certainly not off the table. Once our MACD signal turns lower, we will reduce equity exposure again, as I suspect this summer could be trying for the bulls.

Value or Growth

The graph below showing the relative historical performance of a value versus a growth portfolio can be beneficial in understanding recent trends and in forming expectations. Except for short periods where growth beats value, value portfolios have proven to be the better investment choice. However, since the Great Financial Crisis, growth stocks have significantly outperformed value. Why?

There are many explanations, but the one we find most compelling is interest rates. Extremely low-interest rates favor growth stock valuations as the present value formula to assess future cash flows benefits growth stocks more than value stocks. For a more detailed explanation, please read our article, Finance is at Fault.

Will rates eventually get back down to 2021 levels? If so, growth has a better shot of outperforming value in the near future. Is the recent value outperformance a resumption of the historical trend? Time will tell, but choosing correctly can pay significant dividends for investors.

value vs growth historical perspective rally

Low Quality Rally

This year’s market rally has been impressive; however, a look under the hood leaves something to be desired. Thus far, only four stock factors are outperforming the market. Three of them, high volatility, leverage (highly indebted), and short interest (most shorted stocks), are factors that often reflect a poor quality of the underlying stocks. Growth is only marginally outperforming. Quality factors like value, high dividends, and profitability are lagging. While the quality of leaders is poor, such is often the nature of a bottoming process. Frequently, those stocks/factors that were the laggers in a bear market are quick to rally when a bottom takes hold. The ARKK ETF, for instance, is up 23% year to date.

factor quality performance 2023 rally

Q4 GDP and Jobless Claims

GDP for the fourth quarter was slightly higher than expectations at 2.9% and slightly off the prior quarter’s 3.2% pace. The quarterly PCE inflation rate was +3.9%, the lowest since the first quarter of 2021. Today, we will learn what the PCE inflation rate was for December. Assuming it is in line with CPI, the Fed will likely only raise rates by 25bps.

While the quarter was strong, there are some odd data anomalies beneath the surface. For instance, residential investment fell by 26.7%, but was offset by significant growth in inventories. While inventory growth boosts GDP, it is not necessarily good. An abundance of inventory often means retailers slow down on new orders until they can clear excess inventories.

Despite technology-related layoffs, initial jobless claims remain very low. Last week 186k people claimed for new jobless claims. Continuing claims, which measures how many of those that filed for initial claims remain unemployed, ticked up by 25k but also remains at historically low levels.

gdp breakdown

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A “Soft Landing” Scenario – Possibility Or Fed Myth?

Optimism is increasing on Wall Street, with investors hoping for a “soft landing” in the economy.

“David Kelly, the chief global strategist at JPMorgan Asset Management, is betting that inflation will continue to ease in 2023, helping the US economy to narrowly escape a recession. Ed Yardeni, the longtime stock strategist and founder of his namesake research firm, is putting the odds of a soft landing at 60% based on strong economic data, resilient consumers, and signs of tumbling price pressures.”Bloomberg

The hope is that despite the Fed hiking rates at the most aggressive pace since 1980, reducing its balance sheet via quantitative tightening, and inflation running at the highest levels since the 70s, the economy will continue to power forward.

Is such a possibility, or is the “soft landing” scenario another Fed myth?

To answer that question, we need a definition of a “soft landing” scenario, economically speaking.

“A soft landing, in economics, is a cyclical slowdown in economic growth that avoids a recession. A soft landing is the goal of a central bank when it seeks to raise interest rates just enough to stop an economy from overheating and experiencing high inflation without causing a severe downturn.” – Investopedia

The term “soft landing” came to the forefront of Wall Street jargon during Alan Greenspan’s tenure as Fed Chairman. He was widely credited with engineering a “soft landing” in 1994-1995. The media has also pointed to the Federal Reserve engineering soft landings economically in both 1984 and 2018.

The chart below shows the Fed rate hiking cycle with “soft landings” notated by orange shading. I have also noted the events that preceded the “hard landings.”

Fed funds rate vs market

There is another crucial point regarding the possibility of a “soft landing.” A recession, or “hard landing,” followed the last five instances when inflation peaked above 5%. Those periods were 1948, 1951, 1970, 1974, 1980, 1990, and 2008. Currently, inflation is well above 5% throughout 2022.

Annual inflation rate

Could this time be different? Absolutely, but there is a lot of history that suggests otherwise.

Furthermore, the technical definition of a “soft landing” is “no recession. The track record worsens if we include crisis events caused by the Federal Reserve’s actions.

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No Such Thing

The Federal Reserve became active in the late 70s under Chairman Paul Volker. Since then, the Fed is responsible for repeated boom and bust cycles in the financial markets and economy.

As noted above, there were three periods where the Federal Reserve hiked rates and achieved a “soft landing,” economically speaking. However, the reality was that those periods were not “pain-free” events for the financial markets. The chart below adds the “crisis events” that occurred as the Fed hiked rates.

Fed funds vs market vs crisis

The failure of Continental Illinois National Bank and Trust Company in 1984, the largest in U.S. history at the time, and its subsequent rescue gave rise to the term “too big to fail.” The Chicago-based bank was the seventh-largest bank in the United States and the largest in the Midwest, with approximately $40 billion in assets. Its failure raised important questions about whether large banks should receive differential treatment in the event of failure.

The bank took action to stabilize its balance sheet in 1982 and 1983. But in 1984, the bank posted that its nonperforming loans had suddenly increased by $400 million to a total of $2.3 billion. On May 10, 1984, rumors of the bank’s insolvency sparked a huge run by its depositors. 

Many factors preceded the crisis, but as the Fed hiked rates, higher borrowing costs and interest service led to debt defaults and, eventually, the bank’s failure.

Fast forward to 1994, and we find another “crisis” event brewing as the Fed hiked rates.

The 1994 bond market crisis, or Great Bond Massacre, was a sudden drop in bond market prices across the developed world. It started in Japan, spread through the U.S., and then the world. The build-up to the event began after the 1991 recession, as the Fed had dropped interest rates to historically low levels. During 1994, a rise in rates and the relatively quick spread of bond market volatility across borders resulted in a mass sell-off of bonds and debt funds as yields rose beyond expectations. The plummet in bond prices was triggered by the Federal Reserve’s decision to raise rates to counter inflationary pressures. The result was a global loss of roughly $1.5 trillion in value and was one of the worst financial events for bond investors since 1927.

2018 was also not a pain-free rate hiking cycle. In September of that year, Jerome Powell stated the Federal Reserve was “nowhere near the ‘neutral rate'” and was committed to continuing hiking rates. Of course, a 20% meltdown in the market into December changed that tone, but the hike in interest rates had already done damage. By July 2019, the Fed was cutting rates to zero and launching a massive monetary intervention to bail out hedge funds. (The chart only shows positive weekly changes to the Fed’s balance sheet.)

Fed QE programs vs market

At the same time, the yield curve inverted, and recessionary alarm bells were ringing by September. By March 2022, the onset of the pandemic triggered the recession.

The problem with rate hikes, as always, is the lag effect. Just because Fed rate hikes have not immediately broken something doesn’t mean they won’t. The resistance to higher rates may last longer than expected, depending on the economy or financial market’s strength. However, eventually, the strain will become too great, and something breaks.

It is unlikely this time will be different.

The idea of a “soft landing” is only a reality if you exclude, in most cases, rather devasting financial consequences.

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The Fed Will Break Something

It’s only a question of what.

So far, the economy seems to be holding up well despite an aggressive rate hiking campaign providing the cover for the “soft landing” scenario. Such is due to the massive surge in stimulus sent directly to households resulting in an unprecedented spike in “savings,” creating artificial demand as represented by retail sales. Over the next two years, that “bulge” of excess liquidity will revert to the previous growth trend, which is a disinflationary risk. As a result, economic growth will lag the reversion in savings by about 12 months. This “lag effect” is critical to monetary policy outcomes.

Personal savings vs GDP

As the Fed aggressively hikes rates, the monetary influx has already reverted. Such will see inflation fall rapidly over the ensuing 12 months, and an economic downturn increases the risk of something breaking.

Inflation vs money supply

The slower rate of growth, combined with tighter monetary accommodation, will challenge the Fed as disinflation risk becomes the next monetary policy challenge.

The Federal Reserve is in a race against time. The challenge will be a reversion of demand leading to a supply gut that runs up the supply chain. A recession is often the byproduct of the rebalancing of supply and demand.

While Jerome Powell states he is committed to combatting inflationary pressures, inflation will eventually cure itself. The inflation chart above shows that the “cure for high prices is high prices.”

Mr. Powell understands that inflation is always transitory. However, he also understands rates cannot be at the “zero bound” when a recession begins. As stated, the Fed is racing to hike interest rates as much as possible before the economy falters. The Fed’s only fundamental tool to combat an economic recession is cutting interest rates to spark economic activity.

Jerome Powell’s recent statement from the Brookings Institution speech was full of warnings about the lag effect of monetary policy changes. It was also clear there is no “pivot” in policy coming anytime soon.

lag effect, The Lag Effect Of The Fiscal Pig & Economic Python

When that “lag effect” catches up with the Fed, a “pivot” in policy may not be as bullish as many investors currently hope.

We doubt a “soft landing” is coming.

Real Value Versus Wall Street Value

A shift to stocks that offer real value and dividends is one of our key investment themes to start the year. We say “real value” versus plain old “value” as the term value can be misused, especially by ETFs and mutual funds. In our recent article, Passive Value Investors Are Not Value Investors; we compare Proctor & Gamble (PG) with Stanley Black & Decker (SWK) to show how Wall Street “value” stacks up against a stock offering real value. The article shows that revenue and earnings growth trends clearly favor SWK. Further, as we highlight below, SWK is much cheaper across many valuation metrics. Despite the differences, PG is a top ten holding of most value ETFs, while SWK is often negligible.

The article makes a strong case that SWK offers more value for investors. However, we fully know that passive strategies have warped the investment environment. To wit, we start our summary as follows:

Any rational investor staring at valuations and fundamentals would likely choose SWK over PG. Any rational investor gauging where investor dollars flow would choose PG over SWK.

While stocks like SWK, offering real value, maybe the better value play versus companies like PG, if investors continue to chase what Wall Street conveniently deems value, then real value stocks may become even cheaper. Disclaimer- We currently own PG and SWK in our equity model.

value pg swk

What To Watch Today

Economy

  • 8:30 a.m. ET: Chicago Fed Nat Activity Index, December (-0.05 prior)
  • 8:30 a.m. ET: GDP Annualized, quarter-over-quarter, Q4 Advance (2.6% expected, 3.2% prior)
  • 8:30 a.m. ET: Personal Consumption, quarter-over-quarter, Q4 Advance (2.8% expected, 2.3% prior)
  • 8:30 a.m. ET: GDP Price Index, quarter-over-quarter, Q4 Advance (3.2% expected, 4.4% prior)
  • 8:30 a.m. ET: Core PCE, quarter-over-quarter, Q4 Advance (3.9% expected, 4.7% prior)
  • 8:30 a.m. ET: Advance Goods Trade Balance, December (-$88.5 billion expected, -$83.3 billion prior)
  • 8:30 a.m. ET: Wholesale Inventories, MoM, December Preliminary (0.5% expected, 1.0% prior)
  • 8:30 a.m. ET: Retail Inventories, month-over-month, December (0.2% expected, 0.1% prior)
  • 8:30 a.m. ET: Initial Jobless Claims, week ended Jan. 21 (205,000 expected, 190,000 prior)
  • 8:30 a.m. ET: Continuing Claims, week ended Jan. 14 (1.665 million expected, 1.647 million prior)
  • 8:30 a.m. ET: Durable Goods Orders, December Preliminary (2.5% expected, -2.1% prior)
  • 8:30 a.m. ET: Durables Excluding Transportation, December Preliminary (-0.2% expected, 0.1% prior)
  • 8:30 a.m. ET: Non-Defense Cap Goods Orders Excl. Aircraft, December Prelim. (-0.2% expected, 0.1% prior)
  • 8:30 a.m. ET: Non-Defense Cap Goods Shipments Excl. Aircraft, December Prelim. (-0.4% expected, 0.1% prior)
  • 10:00 a.m. ET: New Home Sales, December (612,000 expected, 640,000 prior)
  • 10:00 a.m. ET: New Home Sales, month-over-month, December (-4.4% expected, 5.8% prior)
  • 10:00 a.m. ET: Kansas City Fed Manufacturing Activity, January (-8 expected, -9 prior)

Earnings

Earnings

Market Trading Update

The bulls continued to “buy the dip” yesterday morning following disappointing guidance from Microsoft (MSFT.) Despite the still “bearish” attitude of investors, the market has successfully tested and held both the 200-DMA and the downtrend line from the January highs successfully over the last couple of days. With the markets overbought short-term (top indicator), this back-and-forth action is not surprising.

Furthermore, the market is struggling to break above the 38.2% Fibonacci retracement level from the January peak. A successful break of that level, and we should see an attempt at the 50% retracement at 4166. With the MACD “buy signal” intact, as stated yesterday, we recommend holding current equity exposure levels until the market firmly declares the downtrend is over. That hasn’t happened yet, so holding some extra cash as a hedge remains appropriate.

Market trading update

Credit Spreads and Financial Conditions

Yesterday’s Commentary noted that “stocks and credit spreads are not foreshadowing a recession.” Stock prices are easy to monitor. Credit spreads are a little more complicated. Therefore, let’s look at current spreads versus historical norms.

Credit spreads represent the difference between the yield on a corporate bond index and Treasury yields. The smaller the difference, the easier, or cheaper, lending conditions are for corporations. Often during recessions, credit spreads increase significantly as default risks rise. Despite rising odds of a recession, credit spreads are below historical averages.

The first table shows that single B-rate corporate bonds and better quality bonds trade at spreads and z-scores below the post-GFC average. The second table highlights the spreads between corporate bond rating tiers are also below average, except in the case of B-rated bonds, and worse. In other words, investors are willing to accept a lower-than-average yield premium (i.e., take on more risk) over Treasuries to earn additional yield. In the graphs below the tables, note how spreads popped higher during the recessions of 2000, 2008, and 2020.

corporate credit spreads
credit spread spreads by ratings
credit oas spreads bonds

Volatility and the FOMC Meetings

One of the hallmarks in 2022 was a heightened level of investor anxiety before Fed meetings. Such is not surprising given how closely the S&P 500 has correlated with Fed liquidity and its monetary policy rhetoric. The graph below shows implied volatility (VIX) averaged 28 on FOMC meeting days. The current implied VIX is 19.2, well below the average. As we head into next Wednesday’s FOMC meeting, will volatility spike again, or will investors in 2023 be less concerned about potential Fed actions?

volatility fomc meetings

Future Pension Funding Liabilities

A lot is made of the U.S. government’s social security funding liability. The liability is the difference between the present value of future payments and the amount of money set aside for said payments. The same problem exists for many states regarding pension liabilities. There are only six states (green) that are fully funded. The remaining 44 states will have either to allocate more tax dollars to their pension funds or hope the value of their current invested assets rises quicker than the future liability. A longer-term bear market would be difficult for many states.

pension funding states

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Leading Indicators Warn of Recession Ahead

The U.S. Leading Economic Indicators, compiled by the Conference Board, fell by 1.0%. The decline was the tenth in a row. As shown below, such a streak of consecutive monthly declines has led to seven of the last eight recessions. The pandemic-related recession is the outlier. Given the unexpected and somewhat random nature of the pandemic, it is not surprising that this indicator or any leading indicator could not forecast it. The following quotes are from the report.

There was widespread weakness among leading indicators in December, indicating deteriorating conditions for labor markets, manufacturing, housing construction, and financial markets in the months ahead. The Conference Board’s Leading Economic Indicators continue to decline and foreshadow a recession is coming.

The breakdown of the ten components of the index is interesting. The financial components, primarily a function of asset market expectations, are flat over the last month and six months. Non-financial components, such as ISM, Building Permits, are Consumer Expectations are fully responsible for the streak of consecutive declines in this leading indicator measure. Two of the three financial indicators, stocks and credit spreads, are not foreshadowing a recession, but the yield curves are. Are the stock and corporate bond markets correct, or will they be surprised if the indicator again proves prescient?

leading indicators

What To Watch Today

Economy

  • 7:00 a.m. ET: MBA Mortgage Applications, the week ended Jan. 20 (27.9% prior)

Earnings

Earnings

Market Trading Update

Yesterday, the market started off on the weak side, testing the breakout of the downtrend level. From a bullish perspective, the test of the breakout level is a good first test to see if this rally has some legs. With the market recovering through the day and closing near breakeven, the bullish bias remains. Investors should keep equity exposure for now, expecting a rally to continue. However, the FOMC meeting is next Wednesday, and given the easing in financial conditions, a strong message from the Fed to knock prices down will not be a surprise.

The market bias is improving, but we are not back in a bull market mode. Continue to hold higher cash levels and manage risk accordingly until the market trend becomes clearer.

Market trading update

Financial Conditions Are Easing

As we noted above, financial conditions are relatively easy to measure using the stock, dollar, and corporate bond markets. The graph below shows that financial conditions are now back to similar levels as a year ago when Fed Funds were zero and stocks near their all-time highs. Such investor optimism is not likely to sit well with the Fed. Per a speech Jerome Powell gave in early December: “Officials seek to reduce inflation by slowing the economy through tighter financial conditions—such as higher borrowing costs, lower stock prices, and a stronger dollar—which typically curb demand.

As we approach the FOMC meeting next week, we must ask will Jerome Powell and the Fed once again try to push markets lower and tighten financial conditions.

financial conditions
financial conditions

Navigating Contrarianism

Lance Roberts just published Contrarian Trade which discusses current market sentiment and provides tips on managing investments when many investors are bearish. Per the article:

As Bob Farrell’s Rule Number 9 states:

When all the experts and forecasts agree – something else is going to happen.

As a contrarian investor, excesses are built by everyone betting on the same side of the trade. When the market peaked in January 2022, everyone was exceedingly bullish, and no one was looking for a 20% decline. Sam Stovall, the investment strategist for Standard & Poor’s, once stated:

“If everybody’s optimistic, who is left to buy? If everybody’s pessimistic, who’s left to sell?”

Today, everyone remains bearish, suggesting the possibility of the market doing something no one expects.

The screenshot below is from a recent Twitter poll Lance administered. As shown, over 70% of the 1280 responders expect the market to end lower than it is now.

twitter poll contrarianism

Cyclical Stocks and Goldilocks

As gauged by the SimpleVisor Relative and Absolute reports over the last two weeks, market leadership has shown cyclical industries such as materials, industrials, and financials leading the way higher. Our takeaway is that investors are banking on a goldilocks economy and, thus, no recession. Further, recent weaknesses in technology and growth companies may account for the defensive lean.

The graph below shows a growing divergence between the outlook for manufacturing and the stock price performance of cyclical/defensive stocks. If industry leaders (ISM) are correct, a recession is likely; therefore, the recent outperformance of cyclical stocks may be negated. Conversely, maybe investors are correct, and the broad manufacturing surveys will start to show improvement. Either way, such a divergence is not commonplace over the last eight years.

cyclicals ism manufacturing survey

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Passive Value Investors Are Not Value Investors

Investment management can be silly, just like the title of this article. When researching potential investments, we often must choose between math and facts versus irrational human behavior. For instance, the rise of passive investment strategies has many investors favoring “value” stocks not on valuations or earnings trends but on self-serving Wall Street classifications. As a result, larger companies that meet vague categorizations attract more passive strategy dollars. This makes them even more prominent and further inflates their valuations.

For investors willing to do some work, this circular pattern leaves excellent value stocks in the wake of the behemoth passive value investment liner.

Benjamin Graham

In the words of value investing legend Benjamin Graham-

“The true investor will do better if he forgets about the stock market and pays attention to his dividend returns and to the operating results of his companies.”

As Graham states, value investing is not a popularity contest. It involves picking stocks that trade at cheap valuations and pay dividends. Despite his wisdom, value investing has morphed into buying the largest companies simply because they are labeled “value” by the banks and brokers that are heavily incentivized to grow their asset base on which they earn fees.

To help appreciate the warped investment world, we present two stocks.

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Blind Taste Test

To appreciate what is truly value and what is considered value, we give you a blind investment scenario. Please choose between stock A and stock B.

Stock A is significantly more expensive than B using popular traditional valuation metrics. Stock B is growing its sales and revenues much faster than A. In fact, sales at A have declined slightly over the last ten years.

Before deciding, think about the question in another light. If you were investing in a private business, which would you choose?

We venture to guess that nearly 100% of our readers armed with that limited information would opt for stock B.

We provide one more piece of data. Stock A has a market cap of nearly $350 billion, 27 times that of stock B. Does that sway your decision?

Sadly, that makes all the difference for unknowing passive investors.

Analyzing A and B

Stock A is Proctor & Gamble (PG). The consumer staples company was founded in Cincinnati, Ohio, nearly 200 years ago. PG sells a wide range of well-known consumer products globally. Their top products include Tide, Pampers, Bounty, Gillette, Crest, and a slew of other brands you are likely familiar with.

Stock B is Stanley Black & Decker. The household and industrial tool company was founded in Connecticut and is nearly as old as PG. Like P&G, some of their products are well-known by households globally. They also make industrial tools that may be less familiar. Some of their most popular product lines include DEWALT, Black and Decker, Craftsman, and Cub Cadet.

Before comparing valuations, it’s worth evaluating their revenue and earnings growth over the past ten years. The trend lines help smooth out quarterly gyrations and highlight prevailing trends.

pg swk revenue trends

Revenues at SWK have risen 5.4% annually over the last ten years. The growth has been remarkably predictable. On the other hand, PG experienced a -0.53% annualized decline in revenue over the period. Since 2015 it began trending higher at a 3% annualized rate, still moderately below SWK’s growth rate.

pg swk eps trends

Evaluating earnings per share (EPS) tells a similar story. P&G has increased its EPS by 2.5% annually. Such compares poorly to SWK’s 6.7% annualized growth rate.

More telling, PG has repurchased almost 15% of its shares over the ten years. SWK has only repurchased 4% of its shares. PG’s EPS over the period would be close to flat without buybacks.

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PG vs. SWK Valuations

Revenue and EPS growth are important metrics, but they do not tell whether the stock price represents value. To take the next step, it is vital to compare fundamental valuations, or how much it costs investors to buy a stream of future sales and earnings. The table below shows seven popular valuation methods. In all cases, SWK is hands down significantly cheaper.

pg swk valuations

Value Funds

Based on our analysis, a value fund should greatly prefer SWK over PG. Further, consider that many of PG’s ratios are more expensive than the S&P 500. However, what a value fund should desire and what they own are often two different things.

Vanguard’s Value Index Fund ETF (VTV) has a market cap of 66 billion. It owns over 2% of PG and only 0.07% of SWK.

The well-followed iShares S&P 500 Value ETF (IVE) has a market cap of 21 billion. The fund holds 0.96% of PG and only 0.08% of SWK.

The story is the same for dividend-centric funds. SWK has a 3.73% dividend yield, about 1.25% more than PG. Despite the larger dividend, two of the more popular dividend ETFs, VYM and VIG, allocate 2.5% and 3.00% to PG, respectively. VYM does not hold SWK, and VIG only holds 0.09% of its assets in SWK.  

For passive value funds to grow, they need securities with ample shares that can be bought without grossly affecting the price. The ETF and mutual fund business models financially reward the fund manager for the fund size, not how well they live up to their stated objective. To grow, many value funds stretch the meaning of “value” to increase the universe of acceptable stocks. Often broader definitions of value result in stocks like PG, which may be stable and conservative companies but do not trade at value-like valuations.

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Summary

Any rational investor staring at valuations and fundamentals would likely choose SWK over PG. Any rational investor gauging where investor dollars flow would choose PG over SWK.

And that is the crazy environment we find ourselves. If passive strategies continue to dominate, stocks like PG may continue to outperform stocks like SWK, despite valuations and earnings and revenue growth. However, stocks like SWK offer an increasingly greater value proposition as the trend continues.

In an unstable market, as we may be approaching, SWK and other true value stocks may provide a port in the storm, leaving PG and others vulnerable to selling if the passive investment crowd has a change of heart.

pg swk stock returns

Major Markets Test A Critical Juncture

The S&P 500 and other major markets are testing a critical juncture. As we highlight below, the S&P 500 pushed through the year-old resistance line that stopped all rallies last year. The index also forms a wedge, with the market setting a higher low in late 2022. Wedges often end with sharp moves, up or down, out of the wedge. A “confirmed” break higher could propel the S&P 500 above the critical resistance defining the bearish trend. Lastly, an inverse head and shoulder pattern has formed as we circle. Such a pattern often proceeds a change from a bearish to a bullish trend.

So the billion-dollar question is, how do these patterns resolve themselves over the coming weeks? A lot may ride on the Fed meeting next week, how investors perceive their tone, and what they may or may not do in the coming months. Further, next Friday’s unemployment report and the CPI report in the following week will update investors’ economic and inflation views. It will be necessary to closely follow technical and fundamental analysis and the multitude of buy and sell signals throughout this year, as there are a lot of positive and negative forces at work. Our best advice, stay flexible and try not to be dogmatic.

In the sections below, we share a few thoughts from Wall Street analysts.


What To Watch Today

Economics

  • 8:30 a.m. ET: Philadelphia Fed Non-Manufacturing Activity, January (-17 prior)
  • 9:45 a.m. ET: S&P Global U.S. Manufacturing PMI, January Preliminary (46.0 expected, 46.2 prior)
  • 9:45 a.m. ET: S&P Global U.S. Services PMI, January Preliminary (45.3 expected, 44.7 prior)
  • 9:45 a.m. ET: S&P Global U.S. Composite PMI, January Preliminary (46.4 expected, 45.0 prior)
  • 10:00 a.m. ET: Richmond Fed Manufacturing Index, January (-5 expected, 1 prior)
  • 10:00 a.m. ET: Richmond Fed Business Conditions, January (-14 prior)

Earnings

Earnings

Market Trading Update

Did the market break out of its consolidation and end the bear market that began last year? If the market can hold above the downtrend that confined the rallies since January last year, such may be the case. Furthermore, the inverse head and shoulders pattern we discussed previously is also very close to confirming a potentially stronger move higher. The market can move higher with the MACD signal intact and not exceedingly overbought, along with the relative strength index.

There are a lot of short-term bullish signals, all converging at the current levels. While it is possible that some bad news or an overly aggressive Fed could negate the signals, the bullish undertones suggest not fighting the market at the moment.

Importantly, these are short-term signals that could last a couple of weeks to a few months. Such does NOT negate another correction later this year.

Market trading update

Fundamentals First

We led the Commentary with a shorter-term technical map of what has occurred and what the future may portend. While technical analysis is a very important tool for investors, we mustn’t lose sight of fundamentals and liquidity.

Forefront in our minds is the fact that the Fed has aggressively raised interest rates and reduced liquidity via QT. QT continues on a $95 billion-a-month pace, but rate hikes are likely nearing an end. The bulls are focused on the Fed stalling rate hikes but seem unaware that yesterday’s rate hikes take a long time to fully affect the economy and markets. The graph below shows that the annual rate increase during 2022 was the greatest since at least 1970. These rate hikes may take nine months or even longer before they are fully felt.

fed funds fundamentals

Morgan Stanley’s Michael Wilson is Growing Concerned

One of our fundamental concerns is that the economy slips into a recession and earnings fall well below estimates. Michael Wilson from Morgan Stanley, shows below that its earnings model predicts a steep decline in earnings. Further, the difference between their model and what most analysts expect is large. Per Michael:

Our work shows further erosion in earnings, with the gap between our model and the forward estimates as wide as it’s ever been. The last two times our model was this far below consensus, the S&P 500 fell by 34% and 49%.

morgan stanley earnings expectations

BofA is Turning Optimistic

As we led in today’s Commentary, the S&P 500 is again bumping into its well-established downward resistance line (dotted red line below). The question we face once again is whether or not the index will break above the line and possibly head much higher. Bank of America is increasingly optimistic that the positive breadth of the market favors a breakout this time. Per BofA:

The percentage of stocks above 200-DMAs provides a longer-term indicator of market breadth. Bearish divergences in late 2021 preceded the 2022 correction. Upside breakouts from 2022 bottoms and entering 2023 are positive and a potential bullish leading indicator for U.S. equities.

BofA market breadth improving

They add:

The U.S. top 15 most active advance-decline (A-D) line firmed up after hitting a new low in late December. This sets up a potential double bottom for this breadth indicator of actively traded US stocks by share volume. A decisive breakout would favor U.S. equity upside.

BofA market breadth improving

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Contrarian Trade. Everyone Remains Bearish

From a contrarian investing view, everyone remains bearish despite a market that corrected all of last year. I polled my Twitter followers recently to take their pulse on the market.

Investing poll

Of the 1280 votes cast in the poll, roughly 73% of respondents anticipate the market to be lower throughout 2023. That view also corresponds with our sentiment gauge of professional and retail investor sentiment, which, while improved from the October lows, remains depressed.

Net bullish sentiment vs market

More importantly, investor allocations, particularly among professional investors, remain extremely light, suggesting a much higher level of caution. The following is the 4-week moving average of the National Association of Investment Managers bullish index. While the reading of 25.04 in October coincided with the market low, the current reading of 48.16 remains bearish.

NAAIM average vs market index

As Bob Farrell’s Rule Number 9 states:

When all the experts and forecasts agree – something else is going to happen.

As a contrarian investor, excesses are built by everyone betting on the same side of the trade. When the market peaked in January 2022, everyone was exceedingly bullish, and no one was looking for a 20% decline. Sam Stovall, the investment strategist for Standard & Poor’s, once stated:

“If everybody’s optimistic, who is left to buy? If everybody’s pessimistic, who’s left to sell?”

Today, everyone remains bearish, suggesting the possibility of the market doing something no one expects.

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The Art Of Contrarianism

As we have often discussed, one of the investors’ most significant challenges is going “against” the prevailing market “herd bias.” However, historically speaking, contrarian investing often proves to provide an advantage. One of the most famous contrarian investors is Howard Marks, who once stated:

Resisting – and thereby achieving success as a contrarian – isn’t easy. Things combine to make it difficult; including natural herd tendencies and the pain imposed by being out of step, particularly when momentum invariably makes pro-cyclical actions look correct for a while.

Given the uncertain nature of the future, and thus the difficulty of being confident your position is the right one – especially as price moves against you – it’s challenging to be a lonely contrarian.”

As noted, a majority of investors remain bearish. There are certainly ample reasons to BE bearish:

  1. The Fed is remaining aggressive on monetary policy.
  2. Central banks are reducing liquidity to markets.
  3. Inflation remains problematic.
  4. Earnings remain elevated.
  5. The economy is slowing.
  6. Consumers are running out of savings.

We certainly agree with the more dismal outlook and continue to suggest that investors should be more cautious in their portfolio allocations. However, this is also the point where investors make the most mistakes. Emotions make them want to avoid the risk of loss.

Given that many investors have never witnessed a “bear market,” the current bearing sentiment is unsurprising. The increased price volatility, and subsequent decline in prices, created a substantially higher level of instability. That instability creates “fear” and drives investors to the behavioral bias of “loss aversion.”

Volatility in price

That increased volatility weighs on investor sentiment leading to poor investment decision-making and, ultimately, poor outcomes.

However, if the most fundamental premise of investing is to “buy when everyone is fearful,” investors may again be missing the contrarian opportunity.

With the market negatively positioned, the contrarian trade is an expectation of the unexpected.

  • What if the markets have discounted an economic slowdown?
  • What if earnings remain stronger than currently expected?
  • Could the Fed reverse monetary policy?
  • Have valuations declined enough?

The fundamentally bearish arguments of valuations, earnings, a Fed policy mistake, and a recession are certainly viable outcomes.

However, given that “everyone” is already expecting those outcomes, what happens if something else occurs?

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Navigating A Contrarian Trade

As Bob Farrell’s Rule Number-9 states:

When all the experts and forecasts agree – something else is going to happen.

As a contrarian investor, excesses get built when everyone is on the same side of the trade.

Everyone is so bearish the markets could respond in a manner no one expects.

This is why equities have historically bottomed between 6-to-9 months before the earnings trough.

Equities trough before earnings trough.

There are plenty of reasons to be very concerned about the market over the next few months. Given the market leads the economy, we must respect the market’s action today for potentially what it is telling us about tomorrow. Therefore, there are some actions we can take to navigate for whatever path the market chooses.

  1. Move slowly. There is no rush to make dramatic changes. Doing anything in a moment of “panic” tends to be the wrong thing.
  2. If you are overweight equities, DO NOT try and fully adjust your portfolio to your target allocation in one move. Again, after significant declines, individuals feel like they “must” do something. Think logically about where you want to be and use the rally to adjust to that level.
  3. Begin by selling laggards and losers. These positions were dragging on performance as the market rose, and they led on the way down.
  4. Add to sectors, or positions, that are performing with or outperforming the broader market if you need risk exposure.
  5. Move “stop-loss” levels up to recent lows for each position. Managing a portfolio without “stop-loss” levels is like driving with your eyes closed.
  6. Be prepared to sell into the rally and reduce overall portfolio risk. You will sell many positions at a loss simply because you overpaid for them to begin with. Selling at a loss DOES NOT make you a loser. It just means you made a mistake.
  7. If none of this makes sense to you, please consider hiring someone to manage your portfolio. It will be worth the additional expense over the long term.

Just remember:

“In good times, skepticism means recognizing the things that are too good to be true; that’s something everyone knows. But in bad times, it requires sensing when things are too bad to be true. People have a hard time doing that.

The things that terrify other people will probably terrify you too, but to be successful, an investor has to be a stalwart. After all, most of the time the world doesn’t end, and if you invest when everyone else thinks it will, you’re apt to get some bargains.

Follow your process.

Summers Warns the Fed

Former U.S. Treasury Secretary Larry Summers spoke strongly to CNBC about the necessity for the Fed to continue its fight against inflation despite recent inflation data. Specifically, Summers is concerned that if the Fed and other central bankers do not stay aggressive, the potential for a second round of high inflation is possible. Per Summers:

The greatest tragedy in this moment would be if central banks were to lurch away from a focus on assuring price stability prematurely and we were to have to fight this battle twice

The Fed appears to harbor similar concerns as Summers. Despite inflation peaking and starting to fall rapidly, most Fed members remain very steadfast in their call for higher rates for longer. Fed members are in a media blackout leading to next week’s FOMC meeting. In advance of the blackout this past week, almost all Fed members stressed the need to get Fed Funds to 5% and keep them there for a long time. If the Fed heeds Summers advice, the market is offside. As we share below, the CME FedWatch tool shows Fed Fund futures imply one to two rate cuts by December.

summers fomc fed funds

What To Watch Today

Economy

  • 10:00 a.m. ET: Leading Index, December (-0.7% expected, -1.0% prior)

Earnings

Earnings

Market Trading Update

After a brief spat of “Fed” rate hike panic on Wednesday and Thursday, the market surged on Friday to retest the 200-DMA once again. With the correction last week, the market continues to trade within an ever-tighter compression between rising lows and a declining trend line. This pattern will end sooner than later, and, as stated previously, when the market breaks, it will likely be a substantial move.

Market Trading Update

My best guess is that this market breaks to the upside. However, there is much risk to that call as we head into the FOMC meeting. However, earnings have been decent so far, and outlooks are not as dire as expected (although still pretty bleak), which is giving the markets support. Trade cautiously for now and hold cash. Yes, we will underperform short-term, but once the market breaks out, we will have plenty of time to add exposure and play catch up.

The Week Ahead

We get a little reprieve from economic data until Thursday and Friday. On Thursday, the BEA will release the Q4 GDP. The current Wall Street expectation is +2.7% annualized growth in the fourth quarter. The Atlanta Fed GDPNow is forecasting 3.5%. Either way, growth was strong last quarter, likely keeping the Fed anxious inflation will be tougher to combat. PCE inflation data will be released on Friday. The price index is expected to increase by 0.1% monthly and 4.6% annually.

The FOMC meets the following Tuesday and Wednesday. Therefore Fed members will be in a media blackout this week.

Earnings reports will likely drive the markets. The following table from SimpleVisor shows the earnings expected next week for the holdings of the SimpleVisor Equity Portfolio.

upcoming earnings simplevisor

Rent Relief Coming Soon?

Shelter CPI, predominately rent and implied rent, accounts for about a third of CPI. The recent CPI data point to cooling prices in many sectors except rents. Rental data tends to lag by three to six months, so this CPI input is expected to cool in the coming months, commensurate with real-time rental data. For example, the first graph below, from Apartment List, shows rents have declined in the last four consecutive months. CPI-Shelter has risen between 0.6% and 0.8% monthly in the previous four months.

Looking longer term, there is another reason to suspect rental income may come under pressure. The second graph shows that the number of multifamily units under construction is at a 50-year high. This new supply of apartments will help keep a lid on rents in the coming year or two.

rent prices
rent multifamily new construction

Gold and the Fed

Gold often negatively correlates with real yields. When real yields fall, gold tends to rise and vice versa. Real yields, the difference between bond yields and the expected inflation rate, tend to decline when the Fed moves toward an easier monetary policy. Often the first sign of a Fed pivot from a hawkish policy is when the yield on the 2-year T-bill declines below Fed Funds. That just happened. In the ten times since 1977 that occurred, gold averaged a 15.4% return over the following year. In no case was it down more than 5.3%. Keep in mind the average is skewed higher by the 97% return in 1978. We will release an article on Real Investment Advice in the coming week or two elaborating on the relationship between gold and real yields.

gold fed funds yield curves

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The Debt Limit Is Upon Us Again

The Debt Limit has been reached, and the Treasury is resorting to “extraordinary measures” to keep the government running. While the situation may sound dire, it is the status quo. Since 1960, Congress has acted 78 different times to permanently raise, temporarily extend, or revise the definition of the debt limit. If you fret that this time is different because of the split Congress, have no fear. Both political parties have proven willing to raise the debt cap limit. Of the 78 increases since 1960, 49 occurred under Republican presidents and 29 under Democratic presidents.

From today until they increase the debt limit, the Treasury can still issue debt, but it can’t increase the amount of debt outstanding. Effectively, the Treasury will issue debt commensurate with the maturing debt. Further, the Treasury has nearly $400 billion in its savings account at the Fed. The Treasury forecasts those funds can keep the government running into May. Also, the Treasury will make mandatory payments like social security, welfare, and interest expense on the debt, but it can slow or stop payments for non-mandatory items. Treasury Secretary Janet Yellen is and will continue to warn of default until the cap increases. Negotiating tactics, including default threats, may induce some bond and stock market volatility. But, as we have learned on 78 occasions in the last 62 years, the debt cap limit will be raised.

debt cap limit

What To Watch Today

Economics

  • 10:00 a.m. ET: Existing Home Sales, December (3.95 million expected, 4.09 million prior)
  • 10:00 a.m. ET: Existing Home Sales, month-over-month, December (-3.4% expected, -7.7% prior)

Earnings

Earnings

Market Trading Update

The market pullback has been fairly orderly within the current consolidation process. That narrowing wedge is compressing prices for a breakout in one direction or the other. Given that compression, whichever direction the market takes will likely be an outsized move over the short term.

The MACD buy signal remains intact for now, and the recent overbought conditions are getting reversed. If the market can hold above the 20-DMA and 100-DMA moving averages, which the market tested yesterday, then a move back to the 200-DMA is possible. The 50-DMA will act as initial resistance to any move higher. Given the compression in the market, the next few days could be bumpy as the market awaits the next Fed meeting.

The outcome of that FOMC meeting, either hawkish or dovish, will likely resolve the current consolidation process into a directional move for investors to trade. Remain cautious for now until that market tells us where it wants to go next.

Market Trading Update

P&G- Inflation is Eating into Profits

Earnings and revenues fell for Proctor Gamble (PG) versus last year, although they beat Wall Street expectations. The stock initially fell on the report as the company expects further margin declines this year. They claim it is becoming increasingly harder to pass on higher inflation to their customers. Per CNBC: “P&G is doubling down on its price hiking strategy even as shrinking consumer demand continues to erode sales volume.” Sales, measured in volume, fell 6% last quarter, making it their largest quarterly drop in years. The obvious question facing many retail facing companies is whether they can continue to pass on higher costs to offset inflation and promote growth if the economy slows, unemployment increases, and personal consumption weakens.

PG inflation margins

Labor Market Remains Historically Hot

Initial jobless claims fell to 190k, well below the estimated 215k and last week’s 205k. Despite the recent layoffs from major tech companies, few other sectors appear to be cutting staff. Continuing claims, the most real-time indicator of the employment market, ticked up to 1.65 million, but it is still at a very low level.

The graph below shows that initial and continued claims, as a percentage of the workforce, are at 40-year lows. Continued claims as a percentage of the workforce are rising slightly but below the lowest levels attained during periods with the most substantial economic growth.

initial and continued jobless claims

EPS Estimates Falling Rapidly

The graph below shows that S&P 500 EPS estimates are falling rapidly but still above 2022 levels, portending earnings growth. However, Bloomberg notes that the rate of decline in forecasts is troublesome. Per Bloomberg:

“Profit expectations now stand as arguably the single biggest contrary indicator to the burgeoning optimism. Estimates are moving down at a rate that in recent history has always presaged a recession.”

eps estimates falling

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Monetary Policy. Is The Fed Trying To Wean Markets Off Of It?

Is the Fed trying to wean the markets off monetary policy? Such was an interesting premise from Alastair Crooke via the Strategic Culture Foundation. To wit:

“The Fed however, may be attempting to implement a contrarian, controlled demolition of the U.S. bubble-economy through interest rate increases. The rate rises will not slay the inflation ‘dragon’ (they would need to be much higher to do that). The purpose is to break a generalised ‘dependency habit’ on free money.”

That is a powerful assessment. If true, there is an overarching impact on the economic and financial markets over the next decade. Such is critical when considering the impact on financial market returns over the previous decade.

“The chart below shows the average annual inflation-adjusted total returns (dividends included) since 1928. I used the total return data from Aswath Damodaran, a Stern School of Business professor at New York University. The chart shows that from 1928 to 2021, the market returned 8.48% after inflation. However, notice that after the financial crisis in 2008, returns jumped by an average of four percentage points for the various periods.

Long Term Returns, Long Term Returns Are Unsustainable

We can trace those outsized returns back to the Fed’s and the Government’s fiscal policy interventions during that period. Following the financial crisis, the Federal Reserve intervened when the market stumbled or threatened the “wealth effect.”

Chart showing Fed's QE vs S&P 500 from 2008 to 2022.

Many suggest the Federal Reserve’s monetary interventions do not affect financial markets. However, the correlation between the two is extremely high.

Scatter chart showing cumulative growth of Fed balance sheet vs S&P 500 from 2009 to present day.

The result of more than a decade of unbridled monetary experiments led to a massive wealth gap in the U.S. Such has become front and center of the political landscape.

Chart showing real household net worth vs. GDP from 1995 to 2022.

It isn’t just the massive expansion in household net worth since the Financial Crisis that is troublesome. The problem is nearly 70% of that household net worth became concentrated in the top 10% of income earners.

Pie chart showing breakdown of current total net worth.

It likely was not the Fed’s intention to cause such a massive redistribution of wealth. However, it was the result of its grand monetary experiment.

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Pavlov’s Great Experiment

Classical conditioning (also known as Pavlovian or respondent conditioning) refers to a learning procedure in which a potent stimulus (e.g., food) becomes paired with a previously neutral stimulus (e.g., a bell). Pavlov discovered that when he introduced the neutral stimulus, the dogs would begin to salivate in anticipation of the potent stimulus, even though it was not currently present. This learning process results from the psychological “pairing” of the stimuli.

This conditioning is what happened to investors over the last decade.

In 2010, then Fed Chairman Ben Bernanke introduced the “neutral stimulus” to the financial markets by adding a “third mandate” to the Fed’s responsibilities – the creation of the “wealth effect.”

“This approach eased financial conditions in the past and, so far, looks to be effective again. Stock prices rose, and long-term interest rates fell when investors began to anticipate this additional action. Easier financial conditions will promote economic growth. For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.”

– Ben Bernanke, Washington Post Op-Ed, November, 2010.

Importantly, for conditioning to work, the “neutral stimulus,” when introduced, must get followed by the “potent stimulus” for the “pairing” to complete. For investors, as the Fed introduced each round of “Quantitative Easing,” the “neutral stimulus,” the stock market rose, the “potent stimulus.” 

Evidence Of Successful Pairing

Twelve years and 400% gains later, the “pairing” was complete. Such is why investors now move from one economic report and Fed meeting to the next in anticipation of the “ringing of the bell.”

The problem, as noted above, is that despite the massive expansion of the Fed’s balance sheet and the surge in asset prices, there was relatively little translation into broader economic prosperity.

The problem is the “transmission system” of monetary policy collapsed following the financial crisis.

Instead of the liquidity flowing through the system, it remained bottled up within institutions, and the ultra-wealthy, who had “investible wealth.” However, those programs failed to boost the bottom 90% of Americans living paycheck-to-paycheck.

The failure of the flush of liquidity to translate into economic growth can be seen in the chart below. While the stock market returned more than 180% since the 2007 peak, that increase in asset prices was more than 6x the growth in real GDP and 2.3x the growth in corporate revenue. (I have used SALES growth in the chart below as it is not as subject to manipulation.) 

Chart showing markets disconnected from the economy from 2007 to 2022.

Since asset prices should reflect economic and revenue growth, the deviation is evidence of a more systemic problem. Of course, the problem comes when they try to reverse the process.

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The Great Unwinding

The chart below sums up the magnitude of the Fed’s current problem.

Chart showing government intervention vs. cumulative economic growth from 2008 to 2021.

From bailing out Bear Stearns to HAMP, HARP, TARP, and a myriad of other Governmental bailouts, along with zero interest rates and a massive expansion of the Fed’s balance sheet, there was roughly $10 of monetary interventions for each $1 of economic growth.

Now, the Federal Reserve must figure out how to wean markets off of “life support” and return to organic growth. The consequence of the retraction of support should be obvious, as noted by Crooke.

“Perhaps the Fed can break the psychological dependency over time, but the task should not be underestimated. As one market strategist put it: ‘The new operating environment is entirely foreign to any investor alive today. So, we must un-anchor ourselves from a past that is ‘no longer’ – and proceed with open minds.’

This period of zero rates, zero inflation, and QE was a historical anomaly – utterly extraordinary. And it is ending (for better or worse).”

Logically, the end of Pavlov’s great “monetary experiment” can not end for the better. Once the paired stimulus gets removed from the market, forward returns must return to the basic math of economic growth plus inflation and dividends. Such was the basic math of returns from 1900 to 2008.

In a world where the Fed wants 2% inflation, economic growth should equate to 2%, and we can assume dividends remain at 2%. That math is simple:

2% GDP + 2% dividend – 2% inflation = 4% annualized returns.

Such is a far cry below the 12% returns generated over the last 12 years. But such will be the consequence of weaning the markets off years of monetary madness.

Of course, there is a positive outcome to this as well.

“If Jay Powell breaks the Fed put and takes away the unfair ability of private capital to rape and pillage the system, he will have finally addressed income inequality in America.”Danielle DiMartino-Booth

The bottom line is that fixing the problem won’t be pain-free. Of course, breaking an addiction to any substance never is. The hope is that the withdrawal doesn’t kill the patient.

Yen On A Rollercoaster As The BOJ Disappoints

The Bank of Japan (BOJ) left its short-term interest rate at -.10% and vowed to maintain a 0.50% yield cap on its 10-year notes. Investors were expecting the yield cap to increase and thought the BOJ might raise its short-term interest rate. Instead, the BOJ disappointed, which set the yen and Japanese bonds on a roller coaster ride. As we comment in a section below, the BOJ bought bonds aggressively to keep the ten-year yield below its 0.50% cap.

The problem facing the BOJ is the tradeoff between low-interest rates and its currency. As we wrote in Japanese Inflation: “However, as the BOJ tries to stop rates from rising, they weaken the yen. Japan is in a trap. They can protect interest rates or the yen but not both. Further, its actions are circular. As the yen depreciates, inflation increases and the Japanese central bank must do even more Q.E. to keep interest rates capped.”

The graph below shows the wild volatility the yen experienced following the BOJ announcement. The yen, at times, has had a strong influence on U.S. bond yields and gold prices. Yesterday’s steep decline in U.S. bond yields is likely due to the continuance of the cap, which will continue to incentivize Japanese investors to invest in U.S. Treasury securities and other foreign assets.

japanese yen

What To Watch Today

Economics

  • 8:30 a.m. ET: Housing Starts, December (1.358 million expected, 1.427 prior)
  • 8:30 a.m. ET: Building Permits, December (1.365 million expected, 1.342 million prior)
  • 8:30 a.m. ET: Housing Starts, month-over-month, December (-4.8% expected, -0.5% prior)
  • 8:30 a.m. ET: Building Permits, month-over-month, December (1.0% expected, -11.2% prior)
  • 8:30 a.m. ET: Philadelphia Fed Business Outlook Index, January (-11.0 expected, -13.8 prior)
  • 8:30 a.m. ET: Initial Jobless Claims, week ended Jan. 14 (214,000 expected, 205,000 prior)
  • 8:30 a.m. ET: Continuing Claims, week ended Jan. 7 (1.655 million expected, 1.634 million prior)

Earnings

Earnings

Market Trading Update

Bad retail sales data, plummeting industrial production, and a Hawkish James Bullard spooked the market yesterday sending stocks lower to retest the 50-DMA. The good news is that the decline yesterday was fairly orderly. The bad news is that the market again failed at the downtrend line, putting the recent rally at risk. Importantly, the 50- and 20-DMA have also crossed above the 100-day suggesting a more bullish bias to the markets short-term.

However, don’t dismiss the risk. The weak economic data has not been good for economic outlooks, and there is no hint of the Fed backing off continued rate hikes. While we did add a little exposure for the rally, we are still carrying a very overweight position in cash currently. We remain cautious for now, but if this rally is going to continue, we need to see the market bounce back by the end of the week.

BOJ Fighting to Keep Yields Capped

Following the BOJ announcement, Japanese bond yields shot higher. Accordingly, the BOJ bought many bonds to defend its yield cap. The BOJ owns over 50% of Japanese bonds, and its share is rapidly growing. Thus far, they bought 3% of all outstanding bonds in January. According to George Saravelos of Deutsche Bank,there are some reports suggesting the BoJ may own more than 100% of some benchmark 10yr bonds.” What happens if they run out of bonds?

It is important to remember that quite a few bonds issued by Japan are held to maturity by pension funds, insurance companies, and individual accounts. As such, the BOJ has a more significant share of bonds than the statistics indicate.

Given the lack of a real market, Japanese bond yields are becoming meaningless for investors. Instead, the market is increasingly looking to the derivates market (swaps) for indications of Japanese bond yields. Interest rate swaps allow companies and investors to swap interest rate payments. For instance, a company can issue a three-month note every quarter and swap the payments into a fixed ten-year rate. Such allows them to effectively borrow at a fixed rate for ten years yet take advantage of the demand for short-term debt issuance. These swaps provide global investors with a better indication of Japanese yields. The 10-year swap rate is .90% or .40% above the BOJ’s cap.

The first graph below shows the BOJ maintains an extremely easy monetary policy while the Fed and ECB are aggressively raising rates. Such helps partially explain the yen’s weakness over the last year. The second graph highlights the BOJ has had to intervene in the bond markets more aggressively and with greater frequency since September.

boj interest rates
boj yen bond buying

The Slope of the 200 DMA

The table below shows how the S&P 500 performs relative to its well-followed 200-day moving average (DMA). Many investors like to buy when the index is above the 200DMA and sell below. Based on the table, investors might also want to focus on the DMA’s slope. The graph below the table provides insight into the current situation. As we show, SPY is slightly above the 200DMA, but the moving average is still declining. The 20-day slope of the 200 DMA helps us assess whether the average is flattening and potentially turning higher in the coming days or weeks or picking up speed to the downside. It was flattening from November to early January, but it recently started heading lower again.

200 dma spy
spy s&P500 200 dma slope

PPI and Retail Sales

Inflation slowed more than expected, and retail sales were down more than forecast.

PPI fell to a 6.2% annual rate, well below expectations of 6.8%. The monthly rate was -0.5%, .4% below forecasts. PPI often leads CPI by a few months. Therefore this latest inflation data should bode well for the Fed. Over 50% of the items tracked in PPI are now in deflation. The graph below, courtesy ZeroHedge, shows the monthly decline was the largest since April 2020. It also clearly shows the trend lower over the last 12 months. One other thing to note, CPI is higher than PPI for the time since late 2020. While the difference is insignificant, it should help corporate profit margins if the trend continues.

ppi inflation retail sales

While PPI was good news for the market, retail sales for December paint a concerning picture of personal consumption (60%+ of GDP). It also points to a weak holiday shopping season. Monthly retail sales fell by 1.1%, and the prior month was revised lower by 0.4% to -1.0%. Excluding vehicles and gas, a data point the Fed closely watches, retail sales were down 0.7% versus expectations for a slight .01% decline. The control group, a subset of retail sales data which feeds GDP data, was lower by 0.7%.

Retail sales were lower for a majority of the goods the report tracks.

  • -6.6% Department stores
  • -4.6% Gas stations
  • -2.5% Furniture
  • -1.2% Cars/car parts
  • -1.1% Electronics/appliances
  • -1.1% Online
  • -0.9% Restaurants
  • -0.9% Bars
  • -0.9% Health/personal care
  • -0.3% Clothes
  • +0.1% Sporting/hobby
  • +0.1% Grocery
  • +0.3% Building materials

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0DTE, Volatility is Lurking Behind the Scenes

Despite its growing popularity among retail investors and influence on markets, 0DTE is probably a term most investors are unaware of. 0DTE stands for zero days until options expiration. These are put-and-call options on individual stocks and indexes that expire within 24 hours. As the graph from Goldman Sachs shows, almost half of the options volume on the S&P 500 is 0DTE. Such dwarfs the single-digit rates existing before the pandemic.

Given the extremely limited amount of time until expiration on these options, most of the activity in 0DTE options is likely due to speculators. In many cases, volume on 0DTE options spikes before important economic data releases. Wall Street banks who are on the other side of 0DTE trades must hedge them. To do so, they buy or short the underlying index as it moves in favor of the options owner. The growing concern is that as 0DTE option interest grows, dealers must actively hedge larger amounts. If the options trades are correct, bullish or bearish, banks would have to buy or sell aggressively. Such could exaggerate an already significant market move. It’s not unrealistic to consider the markets may be capable of daily moves exceeding 5% purely due to options hedging.

0dte options call puts

What To Watch Today

Economics

  • 7:00 a.m. ET: MBA Mortgage Applications, week ended Jan. 13 (1.2% prior)
  • 8:30 a.m. ET: New York Fed Services Business Activity, January (-17.5 prior)
  • 8:30 a.m. ET: Retail Sales Advance, month-over-month, December (-0.9% expected, -0.6% prior)
  • 8:30 a.m. ET: Retail Sales Excluding Autos, MoM, December (-0.5% expected, -0.2% prior)
  • 8:30 a.m. ET: Retail Sales Excluding Autos and Gas, MoM, December (0.0% expected, -0.2% prior)
  • 8:30 a.m. ET: Retail Sales Control Group, December (-0.3% expected, -0.2% prior)
  • 8:30 a.m. ET: PPI Final Demand, month-over-month, December (-0.1% expected, 0.3% prior)
  • 8:30 a.m. ET: PPI Excluding Food and Energy, MoM, December (0.1% expected, 0.4% prior)
  • 8:30 a.m. ET: PPI Excluding Food, Energy, and Trade, MoM, December (0.2% expected, 0.3% prior)
  • 8:30 a.m. ET: PPI Final Demand, year-over-year, December (6.8% expected, 7.4% prior)
  • 8:30 a.m. ET: PPI Excluding Food and Energy, year-over-year, December (5.6% expected, 6.2% prior)
  • 8:30 a.m. ET: PPI Excluding Food, Energy, and Trade, YoY, December (4.6% expected, 4.9% prior)
  • 9:15 a.m. ET: Industrial Production, MoM, December (-0.1% expected, -0.2% prior)
  • 9:15 a.m. ET: Manufacturing (SIC) Production, December (-0.2% expected, -0.6% prior)
  • 9:15 a.m. ET: Capacity Utilization, December (79.5% expected, 79.7% prior)
  • 9:15 a.m. ET: Business Inventories, November (0.4% expected, 0.3% prior)
  • 10:00 a.m. ET: NAHB Housing Market Index, January (31 expected, 31 prior)
  • 2:00 p.m. ET: Federal Reserve Releases Beige Book
  • 4:00 p.m. ET: Net Long-Term TIC Flows, November ($67.8 billion)
  • 4:00 p.m. ET: Total Net TIC Flows, November ($179.9 billion)

Earnings

Earnings

Market Trading Update

The market struggled with the first attempt to break above the 200-DMA yesterday. As earnings start to roll in, the market tone will be set by not just whether earnings can beat estimates but also what companies say about the rest of the year. As noted in yesterday’s Before The Bell video (be sure and subscribe to the channel), the “pain trade” remains higher for the moment. However, with the market’s short-term overbought condition, the market may struggle here for a few days.

However, keep a watch on that downtrend line (blue line) from the 2022 highs. A break above that level will clear the market to move higher.

Market trading update

This year will likely be a year with increased volatility and a year where stock picking will win out over indexing. As such, we recommend using a screener (like the one from SimpleVisor.com) to scan for technically strong stocks with solid fundamentals and dividends. Here is a sample screen of 20 stocks in the S&P 500 that fit the list.

Stock screen

CPI Distribution is Far From Normal

The Cleveland Fed calculates a more stable version of CPI. Its trimmed-mean CPI figure excludes the goods with the top and bottom 15% of price changes. The remainder provides better information about the breadth of prices with less vulnerability to large price changes for a few items. The graph below shows how the price change distribution for individual goods has changed over the last five years.

The distribution curve was normally bell-shaped from June 2018 until the pandemic. Starting in June of 2021, when inflation started surging, the distribution became abnormal, with multiple peaks and longer tails. Recently, the range of distribution is flattening and widening. Essentially, there are few goods with price changes near the median or average. Instead, the CPI average poorly represents the bulk of price changes. Such a circumstance makes forecasting more difficult. Also note, recently there has been a growing number of goods with prices falling. As the economy and supply continue normalizing, we suspect the curve will trend toward a typical bell shape distribution.

distribution of cpi prices

Individuals Are Not Bearish Despite What Some Surveys Say

For all the talk about rampant pessimism, retail investors are still holding stocks. The graph below shows that household equity exposure remains above its long-term average despite last year’s bearish trends and bearish sentiment surveys. Further, despite high yields, bonds and cash remain slightly below longer-term averages.

Interestingly, via its Global Fund Manager Survey, Bank of America claims that institutional investors may be leaning in the other direction. Per its survey, the number of managers claiming to be overweight equities is the lowest since 2008.

aaii bearish survey but bullish holdings allocations

Who Is Buying This Rally?

The graph below shows investors are not piling into the riskier sectors despite the recent rally. The bulk of the investor inflows over the past few weeks are concentrated in government, aggregate bond funds and international markets. The riskier sectors like thematic, small-cap, and cyclical stocks are actually seeing a slight decline in their share of investors’ inflows. If the rally continues, we would like to see the riskier sectors garnering more significant inflows with fewer inflows to the more conservative sectors.

bearish investor inflows despite higher prices.

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Treasury Bonds FAQ

“When the supply and demand for bonds normalize, Treasury bond investors will likely realize that economics, inflation, and other factors warrant much lower yields.”

The quote from Yields are Defying Yesterday’s Logic, written last September, presents our case for why we think bonds might offer a great investment opportunity. Recent inflation data only magnifies our interest in bonds. 

The latest one-month CPI inflation rate is -.1%. The three-month annualized rate of inflation is only 1.83%. We say “only” because many investors focus on the widely followed +6.5% year-over-year inflation rate. Annual inflation rates are essential to track, but they can be very misleading when price trends are changing quickly, as they are.

While other investors fret over yesterday’s inflation, we look toward tomorrow’s inflation. Assuming monthly inflation rates remain low or decline further, as we suspect, bonds offer an incredible opportunity to earn historically attractive real yields. The ten-year U.S. Treasury (UST) note currently offers a yield of 1.75% more than the current three annualized month inflation rate. Such compares favorably to the negative .18% average (using annual CPI) since 2010.

We have discussed the recent attractiveness of bond yields on numerous occasions. What follows are often a slew of questions from readers about buying bonds. As such, we devote this article to a bond-buying FAQ of sorts. This set of questions and answers focuses solely on U.S. Treasury Bonds.

After reading this article, if you are still interested in learning more about bonds, check out our video Bonds Explained Simply. The, YouTube video features Michael Lebowitz and Adam Taggart on the Wealthion channel.

Where Can I Buy Treasury Bonds?

Investors can purchase Treasury bonds at almost all banks, custodians, and brokerage firms. Additionally, the U.S. Treasury Department runs Treasury Direct, selling bonds directly to the public.

The benefit of buying from the Treasury is that they do not charge expenses, management fees, or a bid-offer spread. The drawback is that you can’t sell bonds held at the Treasury. To do so, you must first transfer the bond(s) to a broker/custodian. Furthermore, bonds cannot be transferred from Treasury Direct until you have held the bond for at least 45 days.

Most banks and brokerage firms offer a wide selection of Treasury bonds. It is usually minimal if there is a fee to buy or sell bonds. There is often a bid-offer spread when you buy bonds that have already been auctioned and therefore trade on the secondary market. The spread is the difference between the price a buyer is willing to purchase the bonds and where a seller will sell bonds. The true price usually lies in the middle. The difference is trading expenses. Treasury bonds are among the most liquid assets in the world. Therefore, the bid/offer spread is almost always relatively small.

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What Types of Treasury Bonds Can I Buy?

There are two types of Treasury securities, marketable and non-marketable. Marketable securities can be bought and sold in the secondary bond market before maturity. Non-marketable savings bonds cannot be sold and are difficult to transfer to someone else.

Marketable Bonds

The following are the multiple classifications of marketable Treasury bonds:

  • Bills: short-term securities issued with maturities ranging from four weeks to one year. Bills are sold at a discount to par with no coupon. The yield is solely a function of the purchase price accruing to par by maturity. For example, a one-year bill priced at 95 yields 5.26%. That is calculated by dividing the expected price appreciation by the purchase price. In this case, the price gain will be $5 on a $95 investment. The math is: (100-95) /95.
  • Notes: securities issued with maturities ranging from 2 years to 10 years. Unlike bills, notes pay a coupon every six months. The yield is a function of the coupon and the price. For example, a 2-year note with a price of 98 and coupon of 4% yields 5.02% annually. 4% comes from the coupon, and 1.02% (1/98 per year) is from expected price appreciation.   
  • Bonds: are identical to notes, except they describe all issuances with greater than ten years to maturity.
  • TIPS: TIPS or Treasury Inflation-Protected securities are unique as the principal is adjusted by changes in the Consumer Price Index (CPI). TIPS pay interest every six months and are issued in terms of 5, 10, and 30 years. TIPS should provide a zero percent real return, ensuring you do not lose purchasing power to inflation.
  • FRNs: FRNs or Floating Rate Notes have variable interest payments based on the yield of 3-month bills. FRNs are only issued with two-year terms and pay interest quarterly.

Non-marketable Bonds

Non-marketable Treasury bonds include HH-Bonds, I-Bonds, and EE-Bonds. For more on I-bonds we wrote an article entitled I-Bonds: At 7%, Its Hard To Go Wrong. Information on H, EE, and other bond series is available on the Treasury Direct’s About U.S. Saving Bonds page.

What is Duration?

Understanding where we can buy bonds and the type of bonds available, we can now dive into bond mechanics to appreciate which bond(s) may suit your needs and objectives.

Like any investment, risk and reward are critical factors for consideration. Treasury securities have zero risk of a loss of principal, but there is a risk that the bond’s price will change. If a bond is sold before maturity, such a loss can become permanent.

Let’s explore duration, the trade-off between price and return.

The yield example in the Treasury notes section above shows how price and coupon factor into the yield. The coupon, except with FRNs, is fixed; therefore, price is the variable determinant of a bond’s yield. As bond prices fall, yields rise, and vice versa. The question is how much bond prices will rise or fall for a given change in its yield.

Duration in Practice

Duration measures the sensitivity of price to a change in yield. Generally, a bond’s duration is always shorter than its time until maturity, except for bills and zero-coupon bonds, which are virtually equal.

The current ten-year UST (4.125% 11/15/2032) note has a duration of 8.173. If the yield on the note falls by 1%, the price should increase by 8.173%. Similarly, it will fall by 8.173% if the yield increases by 1%.

The lower the coupon, the closer the duration is to the time until maturity. Additionally, the duration will shift with price but not significantly.

With an understanding of duration, we can assess the risk and reward of bonds and better compare our options. Using our 10-year note with a duration of 8.173, if we think there are equal odds the yield rises or falls by 2%, then there is an equal chance we could make or lose approximately 16.3% from price changes in addition to the 4.125% annual coupon. Ergo, including the coupon payment, the note should provide about 20.5% upside or 12% downside if the note’s yield shifts by 2%.   

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Which Maturity Bond Should I Buy?

This is the most popular question we get.

Answering it requires appreciating the following two questions.

  • What is your risk threshold?
  • Why are you buying the treasury bond?

Duration, as we shared earlier, helps to evaluate price risk. For perspective on how much yields can change and the potential risk of buying the bond, it is worth looking at recent yield ranges and yield changes over prior economic and market environments.

Regarding the purpose of buying the bond, it is constructive to understand if the purchase is speculative, a long-term buy-and-hold investment, or a higher-yielding option for cash until stocks or other assets offer a better risk/return profile.

Speculative Traders

The bond’s duration should guide your expectations for how potential yield changes across the maturity spectrum will affect prices. For example, if you think 2-year notes will fall by 3% in yield and 10-year notes will only fall by 1%, then you must decide between a potential profit of approximately 6% for the 2-year note or around 8% for the ten-year note. Mind you, the 10-year note offers a higher potential return but more risk if you are wrong.

Buy and Hold Investors

Buy-and-hold investors should focus on the current yield and not on potential price changes. In this case, the investor must decide which term and yield profile best suit one’s investment needs.

Parking Cash

Many anxious equity investors are flocking to Treasuries to lock in high yields on their cash. If such is your goal, you should consider short-term Treasury Bills. The price risk and interest rate risk of holding Bills are minimal. In the section below titled Reinvestment Risk, we advise on choosing the proper bill maturity.

Coupon or Yield?

When we wrote this article, Fidelity offered three unique two-year notes maturing on December 31, 2024. Their respective yields in the far-right column are virtually identical. The difference between the notes is in their prices and coupons.

If income generation is a priority, the middle Treasury bond with the 4.25% coupon would best serve your needs. The other bonds offer lower coupon payments but, in exchange, provide more price appreciation. There are potential tax implications when comparing coupons to price changes, so please check with a tax expert to ensure you make the most appropriate decision.

fidelity bond coupon yield duration maturity

Reinvestment Risk- What’s the Right Maturity for me?

To help understand reinvestment risk and select the proper bond maturity, we present an investor deciding between three-month and six-month bills. The decision should be based on your expectations for bond yields. Specifically, in this case, what will a 3-month bill yield three months from now?

Assume the current 3- and 6-month bills yield 4.00% and 4.25%, respectively. You can lock in 4.25% for a 6-month term or take a risk and buy the 3-month bill at 4.00%. If you select the three-month bill, you will need to buy another 3-month bill in three months. If the yield in three months exceeds 4.50%, choosing two shorter bills versus the six-month bill was wise. However, if the Fed starts cutting rates aggressively in the next three months, you would have been much better served to lock in the higher rate for the six months.

You can use the same weighted average math to compare two or more bonds with differing maturities.

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Barbell Strategy

A barbell strategy entails buying multiple bills, notes, and or bonds with varying maturity dates. The benefit of purchasing multiple bonds with staggered maturities versus one large bond is the diversity in coupons and duration. The barbell strategy also provides liquidity as bonds mature. Lastly, having bonds mature at various points during an investment cycle can reduce reinvestment risks.

Mutual Funds and ETFs

Many investors choose to let professionals manage bonds for them. ETFs and mutual funds have become very efficient and offer specific bond portfolios. Further, fees and expenses for many such funds are reasonable. Maybe most enticing, funds and ETFs are easy to buy and sell, offering investors ease in managing liquidity.

Summary

This article only scratches the Treasury bond surface. That said, we hope it provides some answers to help you better consider Treasury bond holdings and, specifically, what types of bonds may be best for you.

If you want information on how we can help you manage bond portfolios, please fill out our How Can We Help form, and we will get back to you.

Banks Kick Off Earnings Season

Earnings from the big banks were generally good, but the banks expressed concern about the economy. JP Morgan initially traded lower despite beating expectations on earnings and revenues. Of concern, the bank built its loss reserves by $1.4bn. While more than expected, it pales compared to the $18 billion added in 2020. The bank warned its net interest income would be slightly lower than expected. Such is not surprising, given the steeply inverted yield curve. Per Jamie Dimon, courtesy Zero Hedge: “Commenting on the results, JPM CEO Jamie Dimon said “the US economy currently remains strong with consumers still spending excess cash and businesses healthy,” but warned that “we still do not know the ultimate effect of the headwinds coming” with the bank warning of “modest deterioration” in the macro outlook.”

Bank of America (BOA), like JPM, beat on earnings and revenues. They also increased their provision for credit losses and reserves more than was expected. The bank has similar concerns as JP Morgan. Concerning their reserves building: “(it was)primarily driven by loan growth and a dampened macroeconomic outlook.

The critical issues in 2023 for banks are the potential for “deterioration” of the economy leading to credit losses and the dampening of net interest income due to inverted yield curves. As we share below, JPM shares have handily beaten BAC over the last six months.

banks earnings

What To Watch Today

Economy

  • 8:30 A.M. ET: Empire Manufacturing, November (-8.6 expected, -11.2 prior)

Earnings

Earnings

The Pain Trade Is Higher

Read The Full Report

Interestingly, despite the Fed continuing to send warnings, “Fighting the Fed” has become the bull’s new mantra. From one economic report to the next, bullish investors continue to look for any reason to buy stocks in hopes the Fed will pivot soon. Such was the case this past week as the markets rallied again, heading into the much-anticipated inflation report.

However, before we dig further into that topic, a review of this week’s market action reveals some decidedly bullish developments but also some risks.

From the bullish side of the ledger, the outlook for 2023 has statistical support for a positive outcome. After having a negative year in 2022, the markets were visited by “Santa Claus,” although very late, and the first 5-days of January turned out a positive return. As the table below shows, there are only a few periods in history where this has occurred, and each yielded positive returns in the following year.

Furthermore, there is also a bullish pattern developing in the S&P 500. The market has recently established a higher low and potentially formed a “right shoulder” of an “inverse head-and-shoulders” technical pattern.

“An inverse head and shoulders, also called a “head and shoulders bottom”, is similar to the standard head and shoulders pattern, but inverted: with the head and shoulders top used to predict reversals in downtrends.

This pattern is identified when the price action of a security meets the following characteristics: the price falls to a trough and then rises; the price falls below the former trough and then rises again; finally, the price falls again but not as far as the second trough. Once the final trough is made, the price heads upward, toward the resistance found near the top of the previous troughs.”Investopedia

Head and Shoulders Market Low

With the market approaching the downtrend line from last year’s peak, and as shown below, a higher low and tightening consolidation suggests a higher move is possible. While the market is short-term overbought, the MACD buy signal continues to suggest the “pain trade” is higher for now.

Market Trading Update

Importantly, this is just an improving technical picture for the market short-term. The breakouts have not happened yet, and may not. However, given the technical improvement, a break above the downtrend and the 200-DMA will set targets between 4200 (50% retracement) and 4360 (61.8% retracement) of last year’s decline.

Market Trading Uddate 2

While the current “pain trade” appears to be higher, there are still many risks to the market. Such is especially the case as we head into earnings season and the next Fed meeting. Therefore, it is important to remain cautious until the markets declare themselves. We remain overweight in cash, and our bond duration remains short of our benchmark index. However, we will adjust our holdings accordingly if these technical patterns mature.

The Week Ahead

This holiday-shortened week will not be short on potential news events. On Wednesday, we get another round of inflation data with the release of PPI. Economists expect the monthly rate to fall by 0.1%, bringing the annual rate to +6.9%. Also, on Wednesday, analysts expect retail sales to decline by 0.4%. If so, the year-over-year rate will be 5%, or -1.5%, on an inflation-adjusted basis. The Philadelphia Fed will release its survey of business conditions on Thursday.

There will be a host of Fed speakers making headlines. Thus far, they all seem united, thinking the Fed will not cut rates this year. The divergence between the market-implied pivot and the Fed’s stubbornness is noteworthy. The markets will likely react violently, up or down, when that expectation gap closes.

Lastly, following the major banks last Friday, earnings will be released for an increasing number of corporations. The table below shows the more notable earnings release dates.

corporate earnings

Revisiting The Mother of all Recession Warnings

As we wrote in the Foghorn is Blowing, an inversion in the 3-month 10-year UST yield curve has signaled each of the last eight recessions. It is worth revisiting the yield curve as it has inverted another 40bps since we wrote the article. The four boxes highlight that each time the curve was in an inverted state, whereby the 3-month yield is above the 10-year yield, it reversed course suddenly. Once the curve was flat to positive, a recession occurred. The yield curve steepened by over 4% in the first three cases below. Such a steepening today implies the Fed will resort to a zero-interest rate policy again. The steepening of the curve in 2019-2020 was interrupted by the pandemic and the Fed’s extreme monetary actions.

As we ponder the graph, we are left to wonder how the curve might un-invert. Equally important is what may cause such a steepening. Further, while history can be prescient, we must also consider how this time might be different.

recessions and yield curves

Home Prices Will Fall Further

Lance Roberts published Home Prices Will Likely Fall Further to provide insight into what will likely be a tough market for home sellers. The wealth effect, as we share in Lower Stock Prices are the Fed’s Goal, is a theory by Ben Bernanke. It theorizes that wealth, be it from the stock market or real estate, is an important factor that drives consumption. Homeowners feel wealthier when house prices are surging, as we saw in 2020 and most of 2021. Per Bernanke’s theory, homeowners are likely to spend more when they feel wealthier. The theory also works in reverse. With the Fed wanting to curb demand to stifle inflation, higher rates are an essential tool. More specifically, 6%+ mortgage rates significantly hamper sales and lower home prices and thus crimp demand for other goods and services.

Per Lance:

The reversion in home prices that has begun will likely continue as that excess liquidity continues to leave the economic system. That drain of liquidity, coupled with higher interest rates, and less monetary accommodation, will drag home prices lower. As that occurs, the “home equity” that many new buyers had in their homes will dissipate as homeownership costs continue to rise due to higher rates and inflation.

Just as the Fed wants to take some froth out of the stock market, they likely harbor the same goal with the housing market. Home prices will likely fall further unless mortgage rates fall quickly and the economy avoids recession.

new home sales 10 year yields

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The “Pain Trade” Is Higher For Now

The “pain trade” is likely higher over the next few weeks. I touched on this topic in this past weekend’s “Bull Bear Report:” Not surprisingly, the “bullish” short-term outlook garnered a substantial amount of pushback. However, there is more to this outlook than just “rosie optimism.”

Let’s review what I wrote, and then we will expand on why we believe the “pain trade” is higher over the next few weeks.

“From the bullish side of the ledger, the outlook for 2023 has statistical support for a positive outcome. After having a negative year in 2022, the markets were visited by “Santa Claus,” although very late, and the first 5-days of January turned out to be a positive return. As the table below shows, there are only a few periods in history where this has occurred, and each yielded positive returns in the following year.”

Bullish Trifecta for the market

Critically, just because something has always occurred in the past does not mean it MUST happen this time. However, as investors, we must focus on statistical tendencies and invest according to the probabilities rather than the possibilities. At the moment, there are many “possibilities” bullish investors are betting on in the short-term, which have a larger potential “probability” of being wrong.

  • The Fed will pivot and start cutting rates and reversing QT.
  • The economy will avoid a recession.
  • The yield curve inversions (shown below) are wrong this time.
  • The housing market will remain robust.
  • Employment will continue to remain strong.
  • Households will continue to spend despite inflationary pressures.
  • Most importantly, corporate earnings and profits will NOT mean revert.

Notably, 90% of the 10-most economically significant yield curves are inverted. Such has never previously occurred without a recession occurring. Of course, in a recession, economic demand slows as the consumer contracts leading to a contraction in earnings. Such is problematic for the bullish view.

Yield curve inversions

Yes, it is entirely possible this time could be different. However, the probabilities are it likely won’t be. Notably, with valuations still elevated from a historical perspective, prices still need to correct to accommodate higher rates.

Valuations vs Fed Funds Rate

However, in the short term (over the next 1-3 months), the technicals are becoming more bullish, suggesting the “pain trade” remains higher.

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Bullish Technicals

It is called the “pain trade” because it is the opposite of how investors are currently positioned. Investor sentiment, as shown in the chart of net bullish sentiment (an index of both professional and retail investors), remains historically bearish despite improvement since the October lows.

Net bullish sentiment

With investors bearishly positioned, including a large amount of short positioning in the market, it becomes increasingly painful to fight the tape as the market rises. As the market continues to improve, the “pain trade” forces a reversal of positioning, pushing prices higher. As prices increase, the pain rises, causing additional positioning reversals and further increasing prices. The cycle repeats until it is exhausted.

The “pain trade” is usually swift and occurs over one to three months. Once that cycle is complete, the underlying fundamental and economic trends will retake control of the markets.

Such is where we are currently.

From a purely technical perspective, a bullish pattern is developing in the S&P 500. The market has recently established a higher low and potentially formed a “right shoulder” of an “inverse head-and-shoulders” technical pattern.

Head and Shoulders Market Low

With the market approaching the downtrend line from last year’s peak, and as shown below, a higher low and tightening consolidation suggests a higher move is possible. While the market is short-term overbought, the MACD buy signal continues to suggest the “pain trade” is higher for now.

Market Trading Update

Importantly, this is just an improving technical picture for the market short-term.

The breakouts have not happened yet, and may not.

However, given the technical improvement, a break above the downtrend and the 200-DMA will set targets between 4200 (50% retracement) and 4360 (61.8% retracement) of last year’s decline.

Market Trading Uddate 2

There are also improving internals that suggests the “pain trade” may continue for a bit longer.

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Additional Support For A “Painful Trade” Higher

Another indicator that suggests a continued move higher is the number of stocks on “bullish” buy signals. As more stocks begin to participate in the move higher, such tends to feed upon itself. As shown, 63% of the stocks in the S&P 500 have registered bullish buy signals. This indicator has shown marked improvement since the lows of 2022.

Bullish percent indicator

Furthermore, earnings estimates have been cut sharply over the last couple of quarters, and S&P is now expecting a -6.4% decline in earnings from Q3. As shown, as investors begin to bet on a “soft landing” scenario for the economy, expectations are this quarter will be the worst part of the earnings reversion cycle. (Those expectations will likely prove wrong.)

Earnings vs Estimates

We also discussed previously one of the essential supports of the financial markets: share buybacks. To wit:

“Since 2011, 40.5% of the markets advance is attributable to corporate share buybacks. In other words, in the absence of share repurchases, the stock market would not be pushing record highs of 4600 but instead levels closer to 2700.”

In a slow-growth economic environment, there is little incentive to increase capital expenditures, make risky acquisitions, or drastically increase wages and compensation. Therefore, share repurchase announcements, which benefit corporate insiders, have surged. Such translates into roughly $4.8 billion per day of repurchases in 2023. ($1.2 Trillion divided by 250 trading days)

Share buyback announcements.

Adding all these things together provides the support necessary for a “pain trade” higher.

The question is, what happens next?

The Contrarian Trade

We have said before that one of our biggest concerns going into the end of 2022 was that EVERYONE was extraordinarily bearish and confident of a recession. As Bob Farrell once quipped:

“When all experts agree, something else tends to happen.”

With everyone extremely bearish and confident of a recession, such puts the markets into a position where there are few buyers and an overwhelming number of sellers. From a contrarian investment view, that is an ideal setup for a “pain trade” higher, which we have discussed as a rising possibility.

Fortunately, we are now seeing a reversal of that extremely bearish view and, as recently noted by Zerohedge:

“Everyone and their pet rabbit was waiting for a ‘dip’ to buy but there was no ‘dip’ and so everyone is now under-exposed to a FOMO-led rally as talk of a ‘soft landing’ becomes the new narrative.”

Soft landing story count.

Such is precisely the point we discussed previously:

“Interestingly, seemingly terrified investors are still unwilling to sell for the ‘fear of missing out.’ It is worth noting that during previous bear markets, equity allocations fell as investors fled to cash. Such has not been the case in 2022.

Investors seem more afraid of missing the bottom should the Federal Reserve suddenly reverse course on monetary policy. Much like Pavlov’s dogs, after years of being trained to ‘buy the dip,’ investors are awaiting the Fed to ‘ring the bell.’“

Investor equity allocations and 10-year returns.

While there is support for the current “pain trade,” the rally still has many risks.

  • The Fed is still tightening its policy and reducing its balance sheet.
  • The rate hikes of last year have yet to impact the economy fully.
  • Economic growth is slowing.
  • Earnings and profit margins are still historically deviated from long-term growth trends.
  • The massive supports of fiscal stimulus are no longer available.
earnings deviation from growth trend.

Such is especially the case as we head into earnings season and the next Fed meeting. Therefore, it is important to remain cautious until the markets declare themselves.

We remain overweight in cash, and our bond duration remains short of our benchmark index. However, we will adjust our holdings accordingly if these technical patterns mature.

While the “pain trade” is higher for now, the challenge we have with the market “Fighting the Fed” is that historically such has not worked out well.

Homebuilder Cancellations Are Off The Charts

The HOPE analysis we presented in Monday’s Commentary addressed the typical progression of economic data leading to recessions. The H in HOPE stands for housing. Housing is often the first segment of the economy to feel the weight of higher interest rates. The Commentary shows a graph of plummeting homebuilder confidence. Such is not surprising given 6%-7% mortgage rates.

As a result of higher mortgage rates, homebuilders are reporting a massive number of cancellations. Homebuyers who previously agreed to purchase a new home are backing out in record numbers. The graph below from homebuilder KB Homes shows that in the fourth quarter, a cancellation rate of over two-thirds of the contracts they signed. Such is higher than in the first quarter of 2020 when the covid shock first hit. Further, it exceeded the highest industry average cancellation rate of 45% in 2008. Despite higher mortgage rates and cancellations, homebuilder stocks are hanging in there. Over the last six months, the homebuilder ETF XHB has risen 12% and it is in line with the S&P 500 over the last year. Homebuilder stock investors are pricing in a pivot. What if they are wrong?

homebuilder cancellation rate

What To Watch Today

Economy

  • 8:30 a.m. ET: Import Price Index, month-over-month, December (-0.9% expected, -0.6% prior)
  • 8:30 a.m. ET: Import Price Index excluding petroleum, month-over-month, December (-0.3% expected, -0.3% prior)
  • 8:30 a.m. ET: Import Price Index, year-over-year, December (2.2% expected, 2.7% prior)
  • 8:30 a.m. ET: Export Price Index, month-over-month, December (-0.7% expected, -0.3% prior)
  • 8:30 a.m. ET: Export Price Index, year-over-year, December (7.3% expected, 6.3% prior)
  • 10:00 a.m. ET: University of Michigan Sentiment, January Preliminary (60.7 expected, 59.7 prior)

Earnings

Earnings

Market Trading Update

As we will discuss next, CPI came in exactly on estimates, which is rare. However, it was the perfect number, not too hot or too cold. With that, the market did manage another day of gains pushing up into key resistance at the 200-DMA. Today, earnings season gets underway with key reports from the banking sector along with Delta Airlines (DAL) and United HealthCare (UNH). Next week, the deluge of reports will begin, and we will look closely at CEO statements on forward guidance.

As we will discuss in this weekend’s newsletter (subscribe for free email delivery), the market is in the process of developing a more bullish basing pattern. The market has recently established a higher low and potentially formed a “right shoulder” of an “inverse head-and-shoulders” technical pattern.

“An inverse head and shoulders, also called a “head and shoulders bottom”, is similar to the standard head and shoulders pattern, but inverted: with the head and shoulders top used to predict reversals in downtrends.

This pattern is identified when the price action of a security meets the following characteristics: the price falls to a trough and then rises; the price falls below the former trough and then rises again; finally, the price falls again but not as far as the second trough. Once the final trough is made, the price heads upward, toward the resistance found near the top of the previous troughs.”Investopedia

Market trading update 1

With the MACD buy signal intact, if the market can rally above the downtrend resistance and the 200-DMA, there is not much resistance beyond that. From a bearish view, the volatility index fell below 20, which, over the last year, has signaled short-term market peaks. The showdown between the bulls and bears will start today, and we will know who won by the end of next week.

market trading update 2

CPI- A Tale of Two Inflations

CPI came in exactly as the market expected. Monthly CPI fell by 0.1%, bringing down the year-over-year rate to 6.5%. The monthly core rate rose by .3%. CPI, excluding shelter inflation, was down .5% monthly.

Shelter prices, primarily based on rents and imputed rent accounts for about a third of CPI. Shelter CPI rose 7.5% year over year, the highest rate of housing inflation since 1982. CPI shelter is a lagging indicator. It significantly understated housing inflation over the last couple of years and is now overstating it. Likely CPI will fall more rapidly once CPI shelter prices catch up with real rental prices.

The graph below shows the tug of war within the inflation data. Core goods CPI, predominately commodities, are seeing rapid disinflation (blue), yet at the same time, core services (orange), which include shelter prices, are still moving higher. The second graph shows how CPI shelter lags more timely new and existing renter indexes.

commodities and services cpi
rent cpi

Winning the War on Inflation

The New York Times recently interviewed Fed Member Neel Kashkari to elaborate on what it may take to win the war against inflation. Kashkari readily acknowledges that a recession with higher unemployment may be the cost of success. As we wrote in Lower Stock Prices Are the Fed’s Goal, the Fed may likely want stock prices to fall further to help tighten financial conditions, thus lowering inflation. Per the article:

We believe they want lower trending stock prices with controlled volatility until they meet their goals. Hawkish rhetoric, higher interest rates for longer, and QT can help them on their quest.

Within the New York Times article linked above was a paragraph that is worth repeating.

I commented that the financial markets didn’t seem to believe that the Fed would stay the course. The central bank, in its latest forecast, had projected that the Fed Funds Rate would increase to at least 5 percent and that there would be no rate cuts this year. But the markets were pricing in cuts starting in its second half. “I’ve spent enough time around Wall Street to know that they are culturally, institutionally, optimistic,” Kashkari replied. I said it seemed almost as if the markets were playing chicken with the Fed. Kashkari laughed. “They are going to lose the game of chicken, I can tell you that,” he said.

Simply Neel warns investors not to fight the Fed. He believes the Fed will keep rates higher for longer and market expectations for a summer pivot are misplaced.


Treasuries Get More Attractive as CPI Fall

The media focuses on the annual inflation rate, which is now 6.5%. While a helpful inflation indicator, it can be a little misleading as it relies on monthly inflation rates from nearly a year ago. To better indicate recent inflation trends, we can annualize the latest monthly or last three months of data, as shown in the chart below. The current annualized one-month CPI is -.95%, and the three-month rate is +1.83%. Both show that current inflation rates are below the Fed’s 2% target.

Now consider that the 10-yr UST bond yield is 3.55%, which is 1.72% above the three-month annualized rate. From 2015 through 2019, the average spread was .50%. One can easily argue that bond yields will decline rapidly if inflation continues at recent rates.

short term inflation rates

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Home Prices Will Likely Fall Further

Home prices have started to correct as interest rates rose sharply in 2022. However, the real problem for home prices is still coming in 2023 as the standoff between sellers and buyers comes to a head.

However, before we get there, let’s review how we got here.

Since the turn of the century, there have been two housing bubbles, with home prices reaching levels of unaffordability not previously seen in the United States. Such was, of course, due to lax lending policies and artificially low-interest rates luring financially unstable individuals into buying homes they could not afford. Such is easily seen in the chart below, which shows home equity versus mortgage debt. (Home equity is the difference between home prices and the underlying debt.)

Housing bubble 2.0

The current surge in home prices makes the previous bubble in 2008 look quaint by comparison.

At that previous peak in 2007, the equity in people’s homes was around $15 trillion, while mortgage debt stood at $9 trillion. When the bubble popped, home prices collapsed, flipping homeowner’s equity from positive to negative. Home equity is roughly $30 trillion, while mortgage debts have increased to roughly $12 trillion. That is an incredible spread, unlike anything seen previously.

However, this time, the surge in home prices wasn’t due to a surge in lax underwriting by mortgage companies but rather the infusion of capital directly to households following the COVID-19 pandemic-driven shutdown.

Median vs average housing home price

Of course, many young Millennials took that money and jumped into the home-buying frenzy. In many cases, buying sight unseen or willing to pay way over the asking price (thereby inflating home prices.) To wit:

“More and more millennials are sinking huge sums of money into homes they’ve never actually set foot in. While the sharp increase in sight-unseen buying in 2020 was certainly driven by pandemic restrictions, the phenomenon appears to be here to stay, due to the tech-forward nature of millennials and the competitive nature of the housing market.”Insider Business

Of course, the rush to buy a home, and overpaying for it, led to regret.

“The number-one reason for buyer’s remorse: 30% of respondents said they spent too much money. The second most common regret was rushing the home-buying process, with 30% saying their purchase decision was rushed and 26% indicating they bought too quickly.”CNBC

Unfortunately, there will be less demand as the massive flood of money into the housing market from Government stimulus reverses.

At The Margin

The problem with much of the mainstream analysis is that it is based on the transactional side of housing. Such only represents what is happening at the “margin.” Rather, the few people actively trying to buy or sell a home impact the data presented monthly.

To understand “housing,” we must analyze the “housing market” as a whole rather than what is happening at the fringes. For this analysis, we can use the data published by the U.S. Census Bureau.

To present some context for the following analysis, we must first have some basis from which to work. Our baseline for this analysis will be the number of total housing units, which, as of Q3-2021, was 143,613,000 units. The chart below shows the historical progression of the number of housing units in the United States compared to the total number of households and an estimate of the total potential households of buyers over the age of 25. For the estimate, we dividend the total active population over the age of 25 by 1.5 to account for single buyers and couples, who tend to make up the majority.

Total housing units vs households

Not surprisingly, there are currently more houses than households to buy. Such is because several homes are vacant for different reasons, second homes, vacation homes, etc. Such is why, as we wrote previously, there is no such thing as a housing shortage. To wit:

“There are three primary issues that lead to changes in the supply of housing:

  1. Prices rise to the point that sellers come into the market.
  2. Interest rates rise, pulling buyers out of the market.
  3. An economic recession removes buyers due to job loss.

“When those occur, transactions slow down, and inventory rises sharply.”

Not surprisingly, since that article was written in November 2020, just 2-years later, the supply of homes has risen sharply. Such is often a leading indicator of recessionary onsets as well.

months of supply of new homes

Also, sharply rising interest rates pull buyers out of the market.

New homes sales vs 10-year rates

 Another drag on prices in the new year will continue to be inventory coming to market as existing homeowners also try to sell their homes. More inventory and few buyers will equate to a further price drop in the coming year.

Housing home process activity index
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Home Prices To Fall Further

The chart below is the most telling of why home prices will fall further in the coming year. It is a composite index of everything involved in housing activity. It compiles new and existing home sales, permits, and housing starts. The index was rebased to 100 in 1999. The runup in the activity index into 2007 was a function, as noted above, of lax lending policies that led to the collapse in activity in 2008.

Total housing activity index

Following the collapse in 2008, the Fed dropped rates to zero and launched multiple QE programs as the Government bailed out everything that moved. The increase in housing activity over the next decade was unsurprising, and repeated monetary interventions boosted the wealth effect.

However, the sharp jump in housing activity in 2020 resulted from the direct monetary injections into households.

The reversion in home prices that has begun will likely continue as that excess liquidity continues to leave the economic system. That drain of liquidity, coupled with higher interest rates, and less monetary accommodation, will drag home prices lower. As that occurs, the “home equity” that many new buyers had in their homes will dissipate as homeownership costs continue to rise due to higher rates and inflation.

As home price depreciation gains traction, more homeowners will be dragged into selling to retain what value they had. For many Americans, most of their net worth is tied up in the homesteads. As the value fades, the decision to sell becomes more of a panic rather than a need.

While there isn’t a vast wasteland of bad mortgages sitting on the books, as seen in 2008, that doesn’t negate the risk of further home price declines in the coming year.

Not only are further home price declines possible, but it is also probable they could be deeper than many currently expect.

A Golden Cross Promises More Upside

A golden cross occurs when a shorter moving average crosses above a longer moving average. Conversely, a death cross occurs when a shorter moving average falls below a longer moving average. The graph below shows the equal-weighted S&P 500 just experienced a golden cross with the key 50 and 200-day moving averages crossing. The equal-weighted index is not a primary, well-followed index. However, its recent golden cross is a positive sign that the broader market’s breadth is improving. In contrast, the 200- day moving average on the S&P 500 is still 100 points above its 50-day moving average. The S&P 500 must continue to rally for a while to see a golden cross.

Since 1970, the S&P 500 has been returning about 15% gains on average in less than a year after a golden cross’ occurrence. However, golden crosses can result in a false breakout and quickly turn into a death cross. Therefore, one should consider the golden cross pattern but use it alongside other technical indicators for the best results. Additionally, the golden cross may indeed portend a good rally in the coming month or two, but as we saw on three occasions in 2022, double-digit rallies were followed by lower lows.

rsp golden cross

What To Watch Today

Economy

  • 8:30 a.m. ET: Consumer Price Index, month-over-month, December (0% expected, 0.1% prior)
  • 8:30 a.m. ET: CPI Excluding Food and Energy, MoM, December (0.3% expected, 0.2% prior)
  • 8:30 a.m. ET: Consumer Price Index, year-over-year, December (6.5% expected, 7.1% prior)
  • 8:30 a.m. ET: CPI Excluding Food and Energy, YoY, December (5.7% expected, 6.0% prior)
  • 8:30 a.m. ET: Real Average Hourly Earnings, year-over-year, December (-1.9% prior)
  • 8:30 a.m. ET: Real Average Weekly Earnings, year-over-year, December (-3.0% prior)
  • 8:30 a.m. ET: Initial Jobless Claims, week ended Jan. 7 (214,000 expected, 204,000 prior)
  • 8:30 a.m. ET: Continuing Claims, week ended Dec. 31 (1.694 million prior)
  • 2:00 p.m. ET: Monthly Budget Statement (-$60 billion expected, -$21.3 billion prior)

Earnings

Earnings

Market Trading Update

Today is the big CPI report that all traders will be glued to. Much like Goldilocks, the question, as discussed next, is whether the number is too hot, too cold, or just right. The markets seem to be beating on a just right number as stocks rallied strongly yesterday, with the disinflationary stocks (technology) leading the way. Furthermore, earnings season kicks off next week with the banks, so the question is, how much “gas” does the rally have in it?

Technically, the bulls are in control for the moment with the MACD buy signal and our money flow signals intact. With the market breaking above the 50-DMA yesterday, such paves the way for a rally to the 200-DMA and the downtrend line from January. A break above that level will suggest a more bullish market near term.

The markets are getting decently overbought short-term, so don’t forget to take some profits along the way. We added a trading position to our portfolios, with a tight stop, yesterday in anticipation of the CPI report tomorrow.

Market Trading Chart

CPI and S&P 500 Speculation

JP Morgan expects extreme volatility in the stock market if today’s CPI data is released. Yes, you read that right- if the BLS releases the data. Regardless of where CPI is reported, JP Morgan thinks the S&P 500 could fall by at least 2.5% or rise by at least 1.5%. The consensus forecast for annual CPI is 6.6%, down from 7.1% last month. JP Morgan estimates the following S&P 500 moves based on its probabilities for a range of CPI prints:

  • If CPI is greater than 6.6%, the S&P 500 could be down 2.5% – 3% – 15% probability.
  • If CPI meets the estimate or is .1% to .2% lower than consensus (6.4% – 6.6%), the S&P 500 could rally 1.5% to 2% – 65% probability.
  • If CPI is below 6.4%, the S&P 500 could rally 3% to 3.5% – 20% probability.

Based on JP Morgan’s price change estimates and the probability of each estimate, investors should expect the S&P 500 to rise by 1.38% today. Based on Brett Freeze’s 6.9% forecast, investors may want to take cover.

cpi estimates inflation
cpi estimate

Recession? Atlanta Fed Thinks the Economy is Booming

While many economists are concerned about economic growth in 2023, it appears that 2022 may have ended with a bang. The Atlanta Fed GDPNow is forecasting 4.1% real GDP growth in the fourth quarter. The current Wall Street estimate is much less optimistic at a mere 1.1%. If Wall Street is correct, the Fed will be more comfortable taming inflation than if the Atlanta Fed proves prescient. If the Atlanta Fed is close to accurate, we might expect the Fed to raise by 50bps at the coming February 1, 2023, FOMC meeting.

atlanta fed gdp now

Value vs. Growth

Value outperformed growth last year after a 15-year period in which growth held sway over value. The graph below shows how the price performance of world (not just the USA) value versus growth shifted materially last year. Is this a significant shift, as we saw with the dot com bust of 2000, or just another false signal? For those who believe value stocks will outperform in the coming years, we will release, over the coming weeks, a series of Five for Friday articles in SimpleVisor that screen for value/higher dividend stocks.

world value vs growth

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Market Shelter With Dividend Aristocrats

Last year, as the market trended lower, higher dividend stocks sheltered investors from the storm. Within higher dividend stocks are a special breed called dividend aristocrats. To be considered an aristocrat, stocks must pay a consistent dividend and continuously increase the size of their dividend payouts. The graph below shows the performance of NOBL (ProShares Dividend Aristocrat ETF) and the S&P 500. While the price gyrations are certainly correlated, the shelter from the market that NOBL provided was quite impressive.

The ability to provide shelter from market drawdowns results from both the higher dividend yield and quality of earnings. For a corporation to maintain a high dividend and consistently increase it, it must have earnings stability. Further, dividend aristocrats tend to have lower valuations, partly due to the fiscal conservatism they practice. During market drawdowns, this conservatism and low valuations provide a cushion, sheltering investors during tough times.

dividend aristocrats

What To Watch Today

Economy

  • 7:00 a.m. ET: MBA Mortgage Applications, week ended Jan. 6 (-10.3% prior)

Earnings

Earnings

Market Trading Update

The market rallied yesterday following a “nothing burger” of a speech by Jerome Powell. The next big report is the highly anticipated December CPI report could send stocks soaring or sinking. There is currently a wide range of estimates, but a substantially weaker number will put “pivot” hopes back on the table.

With the MACD signal in place, we are adding some exposure. We would like to see a firm break above the 50-DMA to set up a stronger run to, and potentially above, the downtrend line from last year’s highs. A weak CPI report could give us the catalyst to add some of the “dividend aristocrats” to our portfolio and increase equity exposure for a trading opportunity.

Remain cautious, markets are overbought, and we are about to kick off a potentially weak earnings season. So volatility could pick up depending on the trend of reports. We will update this analysis tomorrow once we have the inflation report.

Market trading update

Small Business Employment

Last week’s payroll data showed that small businesses accounted for nearly all the new job growth in December. With the Fed trying to weaken the labor market to quell inflation, it’s worth focusing on small business employment to help us better assess what the Fed may do in 2023. The NFIB puts out a comprehensive monthly survey of small businesses. In its most recent labor market survey, they note:

Forty-one percent (seasonally adjusted) of all owners reported job openings they could not fill in the current period, down three points from November. The share of owners with unfilled job openings continues to exceed the 49-year historical average of 23% but 10 points below its record high of 51 percent last reached in July.

As shown below, the percentage of those surveyed reporting current job openings is off the 2022 peak but well above any other level since the mid-1970s.

small business job openings

Job creation plans have also weakened but remain near the highest levels of the last fifty years.

small business job creation

Tightness in the labor market for small business owners does appear to be easing but make no mistake, the employment market remains exceedingly tight for small business owners. As such, pressure on small business owners to provide higher wages will likely continue, further hampering the Fed’s inflation goals.

nfib small business

More on HOPE

Tuesday’s Commentary presented Michael Kantro’s HOPE cycle. His cycle diagrams the order in which economic data typically deteriorates before a recession. The O, in HOPE, is New Orders from the ISM report. The P is corporate profits. The graph below shows that changes in new orders lead to changes in profit margins by about ten months. Based on the data below, we should expect profit margins to begin falling rapidly. Lower margins along with weakening sales, and higher inventories, will likely lead to lower-than-expected earnings in 2023. Ergo, estimates for 8% EPS growth in 2023 may be way off the mark. While the market has been lower over the last year, the market has yet to price in a recession and moderate decline in earnings. As we stated yesterday, 2022 was about inflation concerns. 2023 will likely be recession and earnings worries.

hope orders and profits

Credit Card Interest Rates Soar With Fed Funds

The Fed publically states it wants to curb consumer demand to quell inflation. Raising interest rates is a crucial tool they use to accomplish such a task. The graph below shows interest rates on credit cards at commercial banks have risen from 14.5% to over 19% since the Fed’s tightening campaign began. While the rate is exceptionally high, and some would argue it is a usurious rate, the difference between credit card rates and Fed Funds has remained constant over the last few years. That said, high-interest rates on credit cards will curtail spending.

The second graph shows the disturbing reality supporting consumption in 2022. The savings rate, at a mere 2.4%, is the lowest it has been since at least 1960. The amount of credit card debt outstanding is up over 15% in the last year. While debt and savings resulted in robust spending, we must ask where consumers will find the means to keep up such spending in 2023.

credit card interest
credit card and savings

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Lower Stock Prices are the Fed’s Goal

You read that right, the Fed wants lower stock prices.

Fed members will not say it as bluntly as we do in our title. But they have a long-held belief that stock prices directly impact the economy and, therefore, inflation. Thus, in the Fed’s efforts to quell inflation, it makes sense that they are likely using their stock market lever, specifically lower stock prices, to help improve the efficacy of monetary policy.

Before we delve into recent Fed comments about asset prices and describe the groundwork that Ben Bernanke laid for the Fed’s stock market theory, we share a quote of Fed Chair Janet Yellen from September 2016:

“It could be useful to be able to intervene directly in assets where the prices have a more direct link to spending decisions.”

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December 2022 FOMC Minutes

Within the minutes of the December 15, 2022 FOMC meeting comes the following statement :

Participants noted that, because monetary policy worked importantly through financial markets, an unwarranted easing in financial conditions, especially if driven by a misperception by the public of the Committee’s reaction function, would complicate the Committee’s effort to restore price stability.

More straightforwardly, financial markets are an important way monetary policy is transmitted to the broader economy. As such, higher stock prices (“an unwarranted easing of financial conditions”) driven by a belief the Fed will pivot to lower rates make it more challenging for the Fed to tackle inflation.

In lay terms, lower stock prices can help the Fed get inflation back to its 2% objective.

Jerome Powell and other Fed members have made similar statements. For example, on Friday, August 26, 2022, Powell made an exceptionally hawkish speech about raising interest rates. The S&P 500 fell over 3% that day as investors expected a more market-friendly tone. On the following trading day, Minnesota Fed President Neel Kashkari responded:

I was actually happy to see how Chair Powell’s Jackson Hole speech was received.

Kashkari is cheering on lower stock prices!

Ben Bernanke Coins the Wealth Effect

In 2003 Ben Bernanke laid the groundwork for the Wealth Effect. His theory associates stock prices with the transmission of monetary policy to the economy.

In a speech entitled Monetary Policy and the Stock Market: Some Empirical Results Bernanke states:

The logic goes as follows: Easier monetary policy, for example, raises stock prices. Higher stock prices increase the wealth of households, prompting consumers to spend more–a result known as the wealth effect. Moreover, high stock prices effectively reduce the cost of capital for firms, stimulating increased capital investment. Increases in both types of spending–consumer spending and business spending–tend to stimulate the economy.

Bernanke argues that additional wealth resulting from stock market gains results in more household spending. While he doesn’t say it in this speech, the Wealth Effect also works in reverse!

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Policy and Stocks are a Two-Way Street

Easy Fed policy, including lower rates and QE, tends to correlate with higher stock prices. Equally important and apropos for today, higher rates and QT are associated with lower stock prices.

The graph below quantifies monetary policy to show the correlation between stock prices and the degree of policy. The degree of Fed policy (red/green) is derived from the level of real Fed Funds and recent changes in the Fed’s balance sheet.

It’s not a perfect indicator, but you can generally see tightening policy (red) led to the significant drawdown in 2008, the 2020 decline, and the recent selloff. Conversely, stocks often trend upward when an easy Fed policy (green) is in place.

fed monetary policy and stocks

Inflation is a function of the supply and demand for goods and services. The Fed holds minimal sway over the supply side of the equation. However, they can, directly and indirectly, influence consumer and corporate demand. Not only do stock market gains or losses influence spending and investment, but interest rates significantly impact demand for specific items such as real estate and autos.

The Fed, aware it has little influence on supply, must target demand to reduce inflation. On November 30, 2022, Powell made it clear that the Fed’s objective is to weaken demand to reduce inflation. 

We are tightening the stance of policy in order to slow growth in aggregate demand. Slowing demand growth should allow supply to catch up with demand and restore the balance that will yield stable prices over time. Restoring that balance is likely to require a sustained period of below-trend growth.

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Controlled Burn of Stocks

Between higher interest rates and QT, the Fed is trying to cool demand and bring inflation to its target. Based on numerous comments like those shared, it also appears the Fed is targeting stock prices to help reduce inflation.

The Fed does not want to plunge stock prices as it could result in significant financial disruptions in which they could quickly lose control. We believe they want lower trending stock prices with controlled volatility until they meet their goals. Hawkish rhetoric, higher interest rates for longer, and QT can help them on their quest. The graph below shows volatility has been higher than average during the recent decline, but it did not spike as in the disorderly declines of 2008 and 2020.

stocks low volatility trend

The Fed likely wants a controlled, low-volatility burn on stock prices. If prices gravitate too far upward or downward from the trend channel, the Fed can adjust liquidity via the combination of QT and its Reverse Repurchase Agreement (RRP) program. Such policy management might explain the clean channel the S&P 500 followed throughout 2022.

stocks s&P 500 trend

Our article S&P 3500 By Year End details RRP and Fed-generated liquidity.

Summary

Bernanke and Yellen acknowledge that influencing stock prices is crucial for the Fed to help them accomplish their goals. Powell is following in their footsteps and, in our opinion, trying to push stock prices lower to help ensure inflation is slayed.

Given inflation remains well above the Fed’s target, we suspect the Fed will try to guide stock prices lower in the foreseeable future. In doing so, the Fed may get inflation back to target and bring valuations back to historical norms as a side benefit.

The risk the Fed faces is that volatility spikes and stock declines get out of hand. Such would not only create financial instability but could significantly hamper economic activity. Likely, inflation would turn to deflation in the said scenario and allow the Fed to get back to its preferred playbook of pumping stocks higher to boost economic activity and get inflation up to its target.

The road ahead for stocks is likely lower until inflation is tamed. If the Fed is successful in a controlled burn of stock prices, we should see rallies from the lower range of the trend channel and declines from the upper end. Both extremes may very well present trading opportunities.

In market jargon, expect pumps and dumps as stocks grind lower.

The HOPE Cycle

Michael Kantro, CIO of Piper Sandler, uses the HOPE cycle to show the order in which economic activity typically deteriorates before a recession. Michael’s HOPE model comprises Housing, New Orders (ISM), Corporate Profits, and Employment. Per his graphic below, the HOPE cycle is progressing as it typically does before a recession. Housing and ISM New Orders have peaked and already fallen to levels associated with recessions. On the other hand, corporate profits and employment are only beginning to show signs of trend changes.

The Fed is chasing inflation and appears little concerned about a recession. Its sole focus on inflation prevails even though many economic and market gauges point to an imminent recession. Per Michael Kantro:

The HOPE cycle is moving along in order. How much economic pain will investors celebrate with the backward-looking focus of Fed policy? This is why we think most of the pain will be felt AFTER employment weakens, not before. Inflation is still a larger fear than recession.

Let’s HOPE this time is different.

hope

What To Watch Today

Economy

  • 6:00 a.m. ET: NFIB Small Business Optimism, December (91.5 expected, 91.9 prior)
  • 10:00 a.m. ET: Wholesale Trade Sales, month-over-month, November (0.2% expected, 0.4% prior)
  • 10:00 a.m. ET: Wholesale Inventories, MoM, November Final (1.0% expected, 1.0% prior)

Earnings

Earnings

Market Trading Update

The market rallied out of the gate yesterday but gave it all up, keeping the markets below the resistance cluster at 3900. While the MACD “buy signal” and our money flow indicator has triggered, we are sitting tight until after Jerome Powell’s speech today. We suspect that he will reiterate his hawkish stance, which could pressure asset prices after the recent run higher. Once that is behind us, we should potentially be able to add some selective exposure. While the technicals suggest we could see some higher prices short-term, there are still bearish dynamics at play which could limit rallies for now. Trade accordingly.

Money flow indicator

What’s Hot and What’s Not

Over the last few months, SimpleVisor introduced a set of proprietary tools that we use in conjunction with other tools to make portfolio decisions. These technical tools help us view the market and its underlying sectors and stocks in a unique light, providing us with a unique advantage.

Our relative analysis tool uses 13 technical measures to create a score based on the price ratio of sectors or stocks versus the S&P 500. SimpleVisor charts highlight which stocks or sectors are over or underperforming versus the market. This analysis, in conjunction with other technical analyses, allows us to decipher if a stock or sector is continually over or underperforming or if the relationship is due for a change.

Our absolute analysis uses the same 13 technical studies and scores sector and stock prices solely on their prices. Similarly, we can see which stocks or sectors are hot and which are not, and which might be due for a trend change.

The first SimpleVisor graph combines the two analyses for each sector. Nine of the twelve sectors have a positive relative score versus the S&P 500. XLY and XLK are the only sectors underperforming the S&P 500 on an absolute and relative basis. What is going on? Simply, the index’s most prominent holdings (AAPL, MSFT, AMZN, and TSLA) are performing poorly. To better highlight the problem, the second table breaks out the ten largest holdings of XLK. The table allows relative comparison against each other and XLK. As circled, Apple and Microsoft are the most oversold. Visa and Mastercard are the most overbought. Therefore, the takeaway is that a few stocks are having an outsized effect on the sector. Given the index’s weighting, if one looks below the top holdings of the sector, one may find an opportunity.

hot sectors and stocks
hot technology stocks

A Pivot May not be Good News

The graph below from Jeff Weniger supports our view that a Fed pivot may not be the excellent news equity investors are currently making it out to be. As it shows, the first rate cut in 2000 was just after the dot com bubble peak. In 2007, the market initially cheered the rate cut and recorded a new high. As the graph shows, the jolt higher was a massive trap for bullish investors. As we share in the opening section on HOPE, inflation is today’s Fed worry, but a recession is likely tomorrow’s.

pivot

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0dte Options Are Generating Significant Volatility

Recently, we have made note of the enormous amount of same-day expiration options (0dte- zero days til expiration) being traded. These are extremely short-term bets on the market. The amount of these bets is often at its highest in the hours before an economic release that could move the market. For instance, last Friday, the number of 0dte calls hit record levels before the employment report. Currently, there is light 0dte volume. Tier 1 Alpha shares its thoughts on what might be going on.

A similar pattern to Friday with a dearth of 0dte option volume and relatively broad bands of strikes. Our hypothesis is that people are saving their hedging budgets for Thursday’s CPI. This suggests that surprises in economic data run the risk of moving the markets meaningfully.

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